The case for gearing into equities is strong. The volatility might change your mind

The now legislated changes to negative gearing are altering the calculus for Australian investors, with the relative attractiveness of investing in property taking a hit.

Other than new builds or existing properties that were being negatively geared on budget night, the strategy is no longer be available to property investors.

For investors that are still interested in gearing, the question now becomes how they want to utilise that leverage.

However, it’s not quite as simple as just switching from property to equities and calling it a day. Sure, many of the same benefits can be found, but as Vertium Asset Management’s Jason Teh notes, property investors may not be used to the volatility you find in the sharemarket.

“Property either goes up slowly or goes down slowly, so you don't get whipsawed around,” Teh says.

Rekab Advice director and financial adviser Amie Baker adds that the budget changes don’t necessarily make gearing a poor strategy.

“It may simply shift the conversation from gearing into property to considering whether a diversified investment portfolio is a more appropriate way to build wealth over the long term,” Baker says.

“Australians have been comfortable borrowing hundreds of thousands of dollars to invest in residential property for decades. That is already a gearing strategy. The difference is that it is often concentrated into one asset, in one location, and it is highly illiquid.”

As she notes, many investors were accepting relatively low rental yields and banking on the capital growth down the track to “justify the strategy”.

“That has worked for many people historically, but it is still concentration and liquidity risk. Investors are effectively making a significant leveraged bet on a single asset,” Baker says.

“If the budget changes encourage investors to consider a diversified investment portfolio instead, I do not necessarily see that as a negative outcome. The strategy still needs to be appropriate for the client, but diversification, liquidity and access to a broader range of opportunities can be compelling advantages.”

It’s also not just the negative gearing change that will impact investors’ strategies when it comes to leverage, as Teh argues the revised CGT rules materially reduce the attractiveness of a margin loan on individual shares, thanks to what he terms the “asymmetric payoff”.

“Your winners get taxed at the full tax rate, while your losers carry forward those inflation losses, so why would you do it?” he questions.

How gearing works in an equities fund

At its most basic level, gearing is borrowing money to invest more than you could with your own cash alone - whether that is positive, neutral or negative gearing is down to whether the returns cover the cost of servicing the loan.

This wire won’t get into the tax positioning because while the tax deductibility of the loan is an important consideration, as Baker notes, the tax deduction “should never be the reason for implementing the strategy”.

“The strategy needs to make sense based on the client's overall objectives, tax position and expected investment outcomes,” she says.

In terms of how gearing works in an equities fund, it essentially amplifies the movement of the investments.

Say you want $100,000 worth of exposure to a fund, but you only have $50,000 of your own money. You borrow the remaining $50,000, bringing your total position to $100,000. Your equity is $50,000, and your debt is $50,000.

If the fund grows and that $100,000 becomes $110,000, the debt portion hasn't changed and you still owe $50,000. But your equity has grown from $50,000 to $60,000. That's a 20% gain on your own money, even though the fund itself only rose 10%.

“The primary benefit is the ability to accelerate wealth creation over the long term. By using borrowed funds, investors can gain exposure to a larger pool of investments than they could otherwise access using their own capital alone,” Baker says.

Of course, it works in reverse as well. If the fund falls, your losses are magnified in the same way.

If the fund in the example dropped to $90,000, the debt is again still $50,000, but your equity is now $40,000. Exactly like the gain was amplified from 10% to 20%, so too has the loss.

What’s the strategy?

The two most common approaches for investors looking to use a gearing strategy for equities are to either look at a margin loan or borrow against existing equity.

However, as Baker explains, the more important question is what they are gearing into rather than how they are borrowing.

“The real discussion should be around portfolio construction,” she says.

“If investors are moving away from a strategy that relies on a single property, they need to consider how a diversified investment portfolio is constructed, how much income it is expected to generate, what level of volatility they are comfortable with, and whether the expected return justifies the borrowing costs and risk being taken.”

Or, as Teh puts it: “It might make sense from a return perspective, but it might not make sense from a volatility perspective.”

Baker adds that an investor’s tax position is also critical, given that interest on money borrowed for investment purposes is generally deductible, but there is a range of considerations - from marginal tax rate, cashflow position and overall objectives - that will determine whether a geared strategy ultimately benefits the individual.

“The right strategy for one client may be completely inappropriate for another, which is why advice is so important,” she says.

How much volatility is too much?

Something that a property investor may not be accustomed to is day-to-day volatility. Whether the property market is up or down at a given time, there is no real-time tracking of your investment’s value.

Equities are a lot different. Teh explains that not everyone will be able to handle the market “gyrations,” even if, over the long term, the portfolio grows.

“The amplification of gearing happens over the long term and the short term, but if there’s a Liberation Day or US attacking Iran, everything gets amplified if you have a geared portfolio,” he says.

“If you’re willing to hold out long term and just ignore the short term volatility, which obviously sometimes can be quite hair-raising if you've got a geared portfolio, and you do find a fund that grows quite nicely, then that long-term return will be amplified.”

For example, Teh points to the long-term average growth rate for property, which is around 5% per annum over the last decade. If that investment is geared at 50%, then the return is actually 10% per annum, before any interest paid on the loan or other costs.

“Over the decade, that is actually a pretty good return. The people who took advantage of negative gearing 10 years ago, 10% per annum on that type of gearing structure is phenomenal,” he says.

“The same principle still applies for equities, it's just that because of the volatility, I think people are a bit shy of taking margin loans against equity.”

If the same investment were instead made in equities, which have grown at an average of around 10% per annum over the last 10 years, the outcome for a 50% geared portfolio would be around 20% per annum, again before any interest paid on the loan or other costs.

The chart below shows the performance of both ungeared and geared property and equities based on the above returns with $100,000 starting equity.

Based solely on the above modelling, it looks like a no-brainer to opt for a geared equities portfolio. However, to capture those long-term returns, you have to take on the volatility.

Baker agrees, explaining that any investor taking on this strategy needs to understand that things aren’t as neat in real-life as the graph above may make it seem.

“Periods of market decline are inevitable. The timeframe becomes critically important because the strategy needs sufficient time to work through those cycles,” she says.

“Borrowing costs also need to be considered. The investment return must exceed the cost of borrowing over the long term for the strategy to create value. Cashflow is another key consideration. Investors need to understand how the debt will be serviced, where the income is coming from and how the strategy will perform if market conditions become more challenging.”

Liquidity, Baker adds, is also a double-edged sword. While the greater levels of liquidity are no doubt an advantage of having a diversified investment portfolio, they can also introduce behavioural risk.

“Property investors often have a level of forced discipline because their asset is illiquid. Investors with liquid portfolios can react emotionally during periods of market volatility, which can undermine the success of the strategy,” she says.

“Liquidity can also create temptation if an investor's circumstances change. If cashflow comes under pressure, there may be a temptation to access part of the portfolio to meet short-term needs.

“While that flexibility can be beneficial, it can also compromise the long-term strategy, reduce the capital available to generate future returns and ultimately dilute the intended outcome of the investment.”

The tortoise and the hare

What is abundantly clear about gearing is the point that both Teh and Baker consistently reiterate: amplification.

Given this feature of the strategy, Teh argues that investors may be better off utilising it with a fund that has low volatility.

“Not all the volatility is the same because different funds would have different levels of volatility,” he says.

For instance, a fund that has 1.7 times portfolio beta is moving 70% more than the market. When any movement is amplified in a gearing strategy, investing in that kind of fund could be tough to handle.

“If you get a COVID scenario or you get the 2022 tech crash, that portfolio is going to go down roughly 70% more than the market,” Teh adds.

The question then becomes whether the outperformance over the index is worth the additional volatility and risk.

“Why don't we just gear our index fund and it can still get the same volatility [as the higher-risk fund]. If you're happy with 70% more volatility, maybe the index fund can outperform the other fund,” Teh says.

“Let's say a fund is 20% less volatile than the market, which means that it's not going to move around so much, and it delivers slightly less return than the index. Then you think that's a crappy fund, but it's taking 20% less risk.

“Why don't we gear that to the same level of volatility as the index, and suddenly, on a like for like basis, its returns are actually better than the index one.”

To make a like-for-like comparison, each fund's volatility is normalised to match the ASX300's 13.0%. The Tortoise gets there by adding leverage, borrowing at the cash rate plus 4% to amplify its exposure. The Hare gets there by blending in cash to dampen its swings.

On raw returns alone, the two funds look almost identical: both delivered an annualised return of around 7.8% over the period. But, as can be seen in the much sharper rises and falls, the two funds carry very different levels of risk. The Tortoise has an annualised volatility of 8.8%, roughly half the Hare's 17.8%.

"When volatility is normalised, the Tortoise wins the race. The return per unit of risk is the clue that highlights which fund is superior," Teh says.

Looking at this metric, the Tortoise scores 0.885, compared with 0.635 for the ASX300 and just 0.439 for the Hare. 

In other words, the Tortoise is twice as efficient at converting risk into return as the Hare.

Regardless of the level of volatility investors opt to take on, Teh stresses that understanding the risk profile is important so that you don’t “panic and sell out at the wrong time”.

“You need a strong stomach to handle the roller coaster ride that you could get with a geared portfolio, so stick with the long-term plan.”