Gearing 101: Borrowing to increase exposure, and amplify returns

Gearing involves borrowing to increase your investment exposure in order to amplify potential returns. Used over the long term, it can be a great strategy to generate more capital gains and income for clients

It is widely used to help people buy property but can be applied to shares or other assets too. Gearing for these latter purposes was first popularised in Australia in the 2000s when margin loans were launched, however the market has since evolved to include different gearing options to achieve the same results. 

Below is a 101 guide to help advisers incorporate gearing into portfolios and explain the benefits to clients.

What is gearing? 

Gearing means borrowing to increase the size of an investment in order to amplify potential returns. 

A loan allows investors to supplement their own money with capital to purchase additional assets and thus increase their market exposure. 

Such strategies will also magnify any losses suffered by the investor.

Gearing only works if the after-tax returns of the investments is greater than the costs of a loan.

How can it be used?

Gearing can be implemented in several ways. An investor could, for example, take out a loan to buy shares or managed funds. This could be a margin loan or instead involve borrowing against the accumulated equity in a property.

Another alternative is to invest in a fund or managed account which includes gearing as part of its investment strategy – otherwise known as an “internally geared” investment. 
An advantage of this approach is that individuals do not need to borrow cash themselves to gain the potential advantages of a leveraged strategy. This removes the need to apply for a loan and manage the interest repayments. 

Who would benefit?

Gearing is generally considered most appropriate for people with a long-term investment horizon. This can include:

• Wealth accumulators: Younger clients with relatively small amounts of capital and several decades until retirement can use gearing to diversify assets and achieve a higher return over time – either for non-super investments or by using an internally geared fund within their superannuation. The former category would require an investment horizon of at least 10 years and could be used to fund a future house deposit, children’s education or other long term goals.
• Retirees: Retirees using a “bucket strategy” can potentially use gearing if they still have a 20+ year investment horizon. Such a strategy includes a first bucket for spending (one to three years), a second bucket that aims to provide a total return in line with pension drawdown requirements, and a third bucket dedicated to capital growth. This final bucket could use gearing to help generate gains that can be used to top up the first two buckets over time.

What are the risks?

Gearing is not without its risks. 

The biggest risk is that clients’ losses become greater if an investment underperforms. An increase in the cost of borrowing can also eat into overall returns.

A rate rise may also make it more difficult for individuals who’ve taken out a loan themselves to service repayments. In some instance, even the sale of the investment could be insufficient to repay the loan (particularly if an investor had had opted for a high loan-to-valuation ratio). This added complication does not apply to clients with internally geared investments.

For any investor, there is also the risk of regret if a geared investment goes backwards during a market drawdown. This is why education about market cycles – and the long-term nature of investing – should be reinforced to clients who are considering a gearing strategy.

Consider using Russell Investments’ Geared 120 in client portfolios

Russell Investments’ Managed Portfolio – Geared 120 is a great way to integrate gearing into a client’s portfolio and enhance their potential for long term growth. It gives clients access to a geared investment without the complexities of taking out a loan themselves. With borrowing done inside the portfolio, there are no loan agreements and no margin calls. 

Geared 120 is an actively managed multi-asset portfolio, created to provide greater potential returns with exposure to growth assets. The growth investments in the portfolio include Australian shares, international shares, property and alternatives.

Geared 120 portfolio could be a great fit for clients who are in the accumulation phase and/or with a longer investment time horizon. 

To find out more request a call back from your Regional Manager