Geared investments require more than investors who are willing to monitor short-term market activity, it is about accepting a level of risk with specific return goals in mind and trading on conviction. But what does it mean to trade on conviction?

Gearing, leveraged, inverse – what do they mean?

Gearing involves a combination of an investor’s money with other contractual arrangements to enlarge the total amount invested. This means that the returns and losses on the investor's money are magnified compared to what they would be without gearing.

Derivatives, such as futures contracts, are a form of gearing because they only require a fraction of the capital to purchase compared to buying the underlying asset, with the returns (or losses) based on the difference between the contracted futures purchase/sale price and the actual price of the asset at the sell/buy date.

A leveraged long position means that an investor seeks to capture gains from a rising market, but will also be exposed to losses from falling markets. An inverse (also called short) position means that an investor seeks to capture gains from falling markets and will be exposed to losses from rising markets.

The sophistication of gearing strategies and instruments makes them unsuitable for many investors.

Methods of gearing

Geared investment carry higher risks, so they tend to be the domain of highly experienced investors or professionals. In the case of some types of geared investment, there is the potential for losses far beyond the amount invested and they can be complicated to invest in.

The geared investment landscape includes products such as margin loans, contracts for difference (CFDs) and options.

A margin loan involves borrowing an amount of money to invest in an asset combined with a percentage of your own money, where the asset is used as security on your loan. If the value of the asset drops compared to the loan amount, a margin call will be triggered and you’ll need to top-up the difference, reduce your loan amount or sell down the asset.

A CFD is a derivative investment and is an agreement between an investor and a broker to exchange the change in the value of an asset at the end of a set period. Neither party owns the asset during the agreement, it is based purely on expectations of the price differences and payment is made at the conclusion of the contract. CFDs can be complicated and are high risk in terms of the potential to lose beyond the original investment.

Options give investors the choice to buy or sell an asset at a fixed price on a future date, and involves paying a premium upfront. Losses are restricted to the premium should the price of the asset move against the investor and while some options can be traded on exchange they can be complex to price.

The emergence of geared ETPs has started to change the landscape, offering a more accessible alternative to investors. Geared ETPs use a variety of methods to create their positions – some might use borrowing and shares, while others might use derivatives like futures contracts or swaps, but all ETPs restrict losses to the value of the amount invested.

Geared ETPs trade on the stock exchange in a similar way to shares and are designed to be short-term instruments similar to other geared products. Where they also differ from products like CFDs is that losses are restricted to the original amount invested in them. Though somewhat easier to use, they still require monitoring as they are short term tools with the ability to magnify losses in the same way they seek to magnify gains.

Geared ETPs are still relatively new in Australia, but usage is growing. While the ASX noted an increase in leveraged and inverse trading across March and April where market volatility was high, there are still only 8 geared ETPs listed on the ASX. Numbers are far higher in the US and Europe.

Conviction and gearing

Investors in geared products tend to be highly experienced and use them either based on conviction or as a hedging position to manage exposures in other parts of their investment portfolios.

To trade based on conviction is to have a researched view on market direction and trade based on this expectation. For example, an investor who expects the market to rise might take a leveraged long position whereas an investor who expects the market to fall might take an inverse or short position.

To give greater context of how this might work, an investor with the strong conviction that the Nasdaq-100 index will fall when company announcements are made in the next day (which they anticipate to be below expectation) might use a geared ETP like ETFS Ultra Short Nasdaq 100 Hedge Fund (ASX: SNAS) to take an inverse position. By contrast, one who anticipates the company announcements will instead be positive and the Nasdaq-100 index will rise might instead use a leveraged long position in the form of a geared ETP like ETFS Ultra Long Nasdaq 100 Hedge Fund (ASX: LNAS).

Less experienced investors are not excluded from conviction trading, though leveraged investments may be unsuitable for them. Conviction trading can also relate to longer term views. Investors might choose to invest based on expectations for future growth by using buy and hold style investments such as direct shares, managed funds and exchange traded funds (ETFs). An example of this would be having a positive long-term view on the prospects for the robotics industry and using an ETF like ETFS ROBO Global Robotics and Automation ETF (ASX: ROBO) as part of a long-term core portfolio holding.

To leverage or not?

There are a range of reasons leveraged investments may be used by experienced investors. Specific return goals are one aspect, but others include the ability to create an exposure with smaller initial outlay along with the ability to invest in the short-term with minimal disruption to the broader portfolio. For example, an experienced investor wanting a $1 million position in the Nasdaq-100 for a week might use a trading tool like LNAS to create that position with an outlay of approximately $400,000 instead of needing to spend $1 million to purchase the direct exposure. In terms of disruption to a portfolio, this also means an investor would need to free up less money (which they may have had to sell other assets to free up).

Beyond this though, the decision to use leveraged investments comes down to a range of factors specific to the investor.

Risk tolerance, financial situation, needs and objectives are only one part of the story. Investment trading experience, understanding of the complexity of these products and the ability to monitor trades closely are another aspect. While such investments may be appealing for the potential of magnified returns, investors need equally be aware of the potential of magnified losses.

The industry for leveraged and inverse investment products continues to grow, with geared ETPs increasingly available.

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