Industry focus crunches the wrong gears

These days it seems gearing into shares is seen as a panacea for all sorts of financial problems. Need to save tax — draw down a home equity loan and buy shares. Need to diversify your share portfolio — how about gearing via instalment warrants. Five years to retirement and short a nest egg — try margin lending. Need to put some oomph into your super fund — a geared unit trust is the answer.

One could be forgiven for asking just how the financial planning industry got by in its first 15 years or so without this magic elixir of wealth creation. Why has it only been the last few years that the religion of gearing into shares has gathered so many converts with its array of offerings from home equity loans, margin lending, warrants, protected loans and geared unit trusts?

As recently as 1990 there were only one or two margin lending providers, a couple of home equity loans, no warrants and no geared unit trusts. These days the providers of some of these products can be counted in the dozens, with margin lending now topping $10 billion.

If gearing into shares was hardly used just over a decade ago, why has it become so popular and mainstream today?

There are some obvious explanations. Interest rates are much lower today. Back then, the hurdle rates for gearing to work were seen to be high, although inflation and nominal returns were usually higher too.

The good real returns and low volatility from Australian shares in the 1990s, partly in response to these lower rates, has been another factor supporting gearing.

The trend has also been supply driven. Financial services groups hungry for new income sources have come out with a range of innovative gearing products. The fees for financial planners and stockbrokers recommending gearing have also become very attractive, with trails offered on loans as well as the managed funds targeted in gearing.

However, while these factors may explain the growth in gearing in the last decade they do little to justify its role as a mainstream investment strategy today compared to a decade ago. Are we missing something? After all, if gearing is so good, shouldn’t every long-term investor be doing it?

The missing ingredient in all of this is ‘risk’. Of course planners and promoters will point out the higher risk in gearing, but I wonder whether investors really understand what they mean. Usually it is couched in vague terms such as gearing increases volatility or exaggerates gains and losses. But the general implication is that if the client can handle this extra short-term volatility they will still make money in the long term.

The problem is that, mathematically, gearing increases the chance that an investor will lose money, even over the long term. What is this chance? Arguably this changes with market valuations and real interest rates, but simply using longer-term history as a guide it may be as high as 30 to 50 per cent.

If planners thought of the risk of gearing in these terms then perhaps it is not the strategy for the retiree with five years to go, nor many others that are currently being encouraged into gearing products. Perhaps such people could be offered other investment strategies like more innovative fund selection or asset allocation.

Of course, the key determinant of the success of gearing is the actual returns from the investments that one gears into, although this seems to get relatively little attention. The implicit assumption is that gearing into just about any share or managed investments will work. Many will not. Gearing makes sense where there is a high probability of earning an excess return over financing costs (indeed this is the key to many hedge fund strategies) but in many cases this issue is not even understood or properly considered.

Should we be gearing into shares anyway? After all, most listed companies and property trusts are already geared at varying levels. Is their management not in a better position to determine how leveraged their business should be for shareholders?

Of course, if company share prices are trading at a significant discount to fair business value, gearing into them can make sense, but how many companies are trading at such levels today and how many advisers and investors actually take such an opportunistic approach to gearing?

Even if gearing was certain to work over the long term there is also the question of whether most geared investors would ride through bear market periods. The evidence suggests many will not. Just look at what happened recently in the US where the value of margin loans outstanding has fallen by almost half in the last two years. (see graph)

Perhaps the number of people truly suited to gearing into shares really is a very small proportion of the population, as it seemed to be in 1990. Consider how many gearing clients would still be comfortable with their geared arrangements after a one, two or three-year bear market that falls 30 to 40 per cent. Falls of this magnitude have tended to occur at least once and sometimes twice a decade throughout history. Someone geared at 70 per cent will show a loss of 100 per cent (plus interest) if the investment they are geared into falls 30 per cent. The fact that a 30 per cent fall did not happen in the 1990s and the Australian stockmarket has shown low volatility in the last five years should be cause for concern not complacency.

Then there is the increasing number of geared unit trusts and other means to gear super. The gross size of the Colonial First State Geared Share Fund has tripled in the last 18 months to almost $2 billion. Perhaps all these new investors are suited to leveraging their exposure to the CFS’ large company stock picks by two times, or perhaps they just see the fund as it is advertised as “today’s best performing Australian share fund”.

Anyway, does gearing make sense in super? Perhaps in some limited circumstances, but, in my opinion, only if you are already geared outside super, your super fund is already fully exposed to growth assets, you have considered other ways to improve returns (such as increasing exposure to small companies or alternative assets) and you are prepared for the chance that your super could be hurt badly in a bear market.

Perhaps advisers and investors are using the geared share funds after considering all these issues. Then again, having seen the CFS Geared Share Fund used extensively in diversified portfolios where the client holds an equivalent amount in cash (a totally illogical strategy), maybe not.

Then there are products that offer protection of capital over a specific period (typically three to five years) and allow you to borrow 100 per cent to invest in shares and managed funds. In some cases these products will even lend you the interest cost.

Almost by magic they allow those with no money to invest, to place $100,000 or so in shares or managed funds. The lender creates a loan on which they earn an interest spread and the loan creates the demand for a managed fund on which the fund manager and adviser earn fees.

It all sounds great, but given the high interest rates and other costs on these arrangements the chances of actually making money are less than traditional gearing.

I don’t want to scare all investors away from gearing. I myself have had a margin lending account for more than a decade. But I think I understand and accept the risks, am more opportunistic in approach, make an effort to avoid gearing in the same areas as everyone else and consider the margined shares as just a part of my overall portfolio (including ungeared super) that brings my overall gearing level down to between 10 to 25 per cent.

On the other hand, I come across few investors that I believe can easily handle the risks of 50 per cent plus gearing and relatively few investments worth gearing into at such levels.

I expect that many gearing arrangements entered into in the last few years would not be showing a profit after interest and other costs.

However, talk critically about any of these gearing products publicly and you are branded a heretic. As a result the investing public is seeing the overwhelmingly positive picture on gearing into shares.

I return to my earlier question. Why is it that gearing into shares was a rarely used strategy in 1990, but is wildly popular today? The industry was either getting it badly wrong then or is getting it badly wrong now. I’ll leave it for you to decide.