gearing risk by hjkuiw354

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									October 2010



understanding
gearing risk
INTRODUCTION                                   IMPLICATIONS OF GEARING                                With geared funds, borrowing is
     Borrowing to invest is an effective                                                          undertaken by the fund itself. As such,
way of increasing an investor’s asset          1. There is a cost involved. In every              costs, margin calls, cashflow manage-
class exposure, achieving tax benefits            case this includes an interest rate             ment and all the associated accounting
and increasing returns in the process.            cost and, in some cases, additional             occurs at fund level. This means that a lot
However, as with every aspect of financial        management fees.                                of the implications and risks associated
planning, it can only be successful                                                               with gearing are not visible to the adviser
if implemented as part of a sensible           2. The Loan to Valuation Ratio (LVR)               or investor. For this reason, this paper will
strategy. A good strategy is an outcome           indicates the level of debt held by             focus primarily on geared funds.
of thorough consideration of both                 the portfolio. An LVR of 0.5 means
potential rewards and risks.                      that every dollar committed by the
     While gearing is common and                  investor is matched with a dollar               IMPLICATIONS FOR
straightforward, some fundamental                 of debt. In this case, a portfolio is           ASSET ALLOCATION
implications can easily be overlooked in          comprised of 50% debt and 50%                       It may seem obvious that gearing into
the pursuit of improved returns. These            equity. An LVR of 0.33 means that               an asset class increases an investor’s
fundamentals are equally important for            every dollar committed by the                   exposure to it. However, what is not so
both margin lending, geared funds and             investor is supplemented by 50                  obvious is the impact that gearing has on
home equity, so it is worth revisiting these      cents of debt, i.e. the portfolio is            overall asset allocation. As an example,
basics.                                           comprised of 33% debt and 67%                   consider a “growth” portfolio. A typical
                                                  equity.                                         growth portfolio might consist of 10%
                                                                                                  cash, 20% bonds, 10% property and
                                               3. Returns are magnified, but the                  60% equities, for an overall exposure
                                                  borrowing costs must be consid-                 of 70% to growth assets. If 50% of the
While gearing is                                  ered. An LVR of 0.5 will yield a return         equities component is geared with an
                                                  on initial investment double that of            LVR of 0.5, the asset allocation changes
common and                                        the underlying asset return, minus              to the extent the investor has no effective
                                                  costs. Positive returns therefore               exposure to defensive assets whatso-
straightforward,                                  will be slightly less than double the
                                                  return of the underlying asset.
some fundamental
                                               4. Risks are also magnified and
implications can easily                           again, borrowing costs must be
                                                  considered. With an LVR of 0.5,
be overlooked in the                              negative returns will be slightly more
                                                  negative than double the return
pursuit of improved                               on the underlying asset. This is an
                                                  important consideration.
returns. These
                                               5. Because losses are magnified,
fundamentals are                                  the investment horizon should be
                                                  extended as the time to recover from
equally important for                             any potential losses is increased.

both margin lending,                           6. Because investment returns need to
                                                  outpace borrowing costs, any asset
geared funds and                                  return that is less than the prevailing
                                                  interest rate represents a negative
home equity, so it is                             return to investor. Therefore,
                                                  negative returns become much more
worth revisiting these                            frequent. Highly frequent negative
                                                  returns are a serious risk-profiling
basics.                                           consideration.
                                                                                                  This article by Patrick Bennett (above), Head of Research.




                                                                            Shadforth Financial Group Limited | ABN 27 127 508 472 | AFS Licence Number 318613
ever. The impact on the risk profile                             because borrowing costs detract from                         a geared fund that is itself geared with
of the portfolio versus the risk profile                         any positive returns. While the investor                     a LVR of 0.5 is very exposed. A -20%
of the investor is enormous and the                              may be rewarded with an additional                           market return will result in an almost
intended benefits of diversification can be                      return on the upside, this is less than half                 complete loss of capital, as shown in
completely eroded.                                               what they risk losing if markets move                        Table 1.
                                                                 by an equivalent negative amount The                             When combined, margin lending and
THE BORROWING COSTS                                              risk/reward equation is skewed against                       geared fund strategies produce outcomes
REALLY MATTER                                                    the investor. Of equal importance is the                     that no longer bear any resemblance to
    A common misconception is that the                           implication of a 0% return. In the geared                    the behavior of the underlying investment
LVR and the returns of the underlying                            fund, even a 0% asset class return results                   assets. In fact, double gearing strate-
asset will dictate geared fund returns.                          in a negative return to the investor.                        gies produce results that more closely
The LVR and asset return will dictate                                                                                         resemble gambling outcomes. The
the investor’s return before borrowing                           THE RISKS ASSOCIATED                                         potential for high returns is matched with
costs are applied. If underlying asset                           WITH DOUBLE GEARING                                          the potential for large losses and even
returns are substantially positive, then                             Double gearing occurs when                               the complete loss of capital. This is why
the LVR will have a proportionately                              investors use borrowed money to invest                       double gearing should be avoided.
substantial positive impact. If underlying                       in a geared fund. This further multiplies
asset returns are substantially negative,                        the impact on returns, risk and asset                        CONCLUSIONS
then the LVR will have a proportion-                             allocation. However, given that margin                           Borrowing to invest is an aggressive
ately substantial negative impact.                               lending is considerably more expensive                       strategy, whether in the form of margin
Borrowing costs however, will always                             than using geared funds, the potential                       lending or investing into a geared fund.
have a negative impact regardless of the                         upside is more limited while the potential                   As the level of gearing increases, so
direction pre-geared returns are taking.                         downside is considerably worse.                              too should the investment horizon. A
    During good years, returns won’t be                              Double gearing is an extremely                           geared ‘moderate’ portfolio may need
magnified to the same degree that losses                         dangerous strategy. An investor with a                       a similar time to recover from a period
are magnified during bad years. This is                          conservative LVR of 0.25 investing into                      of underperformance as an ungeared
                                                                                                                              ‘aggressive’ portfolio.
                                                                                                                                  Investors should be aware of the
Table 1: Double gearing
                                                                                                                              real risk that is being embedded in their
                               Ungeared             Geared fund, no           Margin lend @            Margin lend @          portfolio. This risk can be either in the
                              investment            margin lending            0.25 LVR into             0.5 LVR into          form of greater losses when markets
                                                                               geared fund              geared fund           underperform, or an asset allocation that
  Return in a                     20%                     32.7%                    41.5%                    61.1%             is no longer aligned with their targeted
  good year                                                                                                                   risk profile. It is better to gear to what is
                                                                                                                              an acceptable level of risk, rather than
  Return in an                    10%                     12.7%                    14.8%                    21.1%             seek a higher return irrespective of the
  average year
                                                                                                                              additional risk.
  Return in a                      0%                     -7.2%                    -11.8%                   -18.9%                Borrowing costs are a relentless
  bad year                                                                                                                    drag on returns, diminishing the ultimate
                                                                                                                              returns to investors irrespective of
  Return in a                     -20%                   -47.2%                    -65.2%                   -98.9%
                                                                                                                              whether the investment itself rises or falls
  disastrous year
                                                                                                                              in value.
Assumed cost of borrowing for the geared fund is 7.25%. The geared fund has a 0.5 LVR. Assumed cost of borrowing for retail
margin lending is 8.75%.




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2         SHADFORTH FINANCIAL GROUP’S UNDERSTANDING SERIES

								
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