Property is not the only asset that can be geared

While geared investment strategies might mean greater risk, they can also mean greater reward, writes Financial Standard.

The concept of gearing an investment is not foreign to Australian investors. Of course, one of the nation’s favourite past times is to debate the pros and cons of negative gearing.

But while they may be familiar with the concept as it pertains to an investment property, they might be less familiar with gearing when it comes to their equities portfolios.

Gearing is when an investor will borrow money to increase the amount they can invest, offering greater exposure to growth assets than capital investments alone and often resulting in favourable tax treatment. And where there’s negative gearing, there’s also positive gearing – in this instance, where the dividend income from shares exceeds the loan repayments.

It’s a strategy that’s typically suited to accumulation-stage investors who are looking to build long-term wealth and are comfortable taking on the heightened risks of magnified losses in falling markets to do so. Retirees can also utilise geared strategies, however it’s typically only recommended for those with an investment horizon of 20 years or more who are using a ‘bucketing’ strategy.

Such strategies are gaining ground in Australia, with many new products having been launched in the past year, including several geared exchange-traded funds. However, David Wilson, who oversees one of the nation’s longest-running geared share strategies, says active management is key when it comes to geared investments.

Wilson, Deputy Head of Australian Equities Growth at First Sentier Investors, says when it comes to geared strategies, you don’t want an index selecting the stocks you invest in.

“You need to very much bear in mind the balanced sheets that you’re investing in and… [with a geared fund] the operating leverage and financial leverage is very much taken into account,” he says.

This is why the First Sentier Geared Australian Share Fund only invests in ASX 100 companies, with Wilson saying many of these companies are perfect candidates for a geared strategy. At any given time, the fund is invested in 30-40 stocks with a typical gearing ratio of 50-60%.

“I think perhaps the quality of companies in the ASX 100 is underappreciated. You’ve obviously got a staple group of mining companies, retailers, insurers, and banks that have delivered pretty solid returns over a long period of time, but you also have the opportunity to invest in companies that have experienced really solid international growth and expanded very effectively overseas,” he explains.

Examples of this include CSL, Goodman Group, and James Hardie Industries; not only are they homegrown success stories, but they’re also global leaders in their respective fields.

"Quality companies, when we invest with a geared strategy, allow us to capture the real strength of those businesses and magnify those returns."

“So, Australia’s had companies that have been able to invest above their cost of capital over long periods of time, and the geared strategy has allowed us to capture that and actually magnify the growth of those businesses.”

The ASX 100 also typically pay generous dividends, and a geared share strategy can typically amplify franking credits.

“The ASX 100 typically has a higher payout ratio and a higher level of franking. By investing in a geared strategy, you not only get the franking and the dividend return on the monies invested, but also on the monies borrowed,” Wilson explains.

“So, you’re actually getting twice as much; the dividend stream and the franking stream.” Of course, many investors utilise gearing themselves, taking a do-it-yourself approach and investing in margin loans or other high-risk instruments like contracts for difference and listed warrants. This can prove costly and complex – more so if the investment is not managed effectively.

Investing via a geared strategy offers other benefits, too – like cheaper borrowing costs as an investor like First Sentier Investors can leverage institutional interest rates. Again, these lower costs increase the return potential.

As Wilson explains: “When you invest in a geared strategy, both gains and losses are magnified, so it works both ways. What it also means is that when markets fall, you are actually required to meet a margin call, we are able to meet that margin call for you in those periods of downturn, rather than being called in by your margin lender.”

“The other important aspect of our geared strategy is that we take the stock selection very seriously, and so we’re able to invest in companies that are both liquid, in terms of market falls and market rises, and we believe also have high quality, resilient, durable businesses that are not affected by volatility in markets.”

The underlying strength of those companies, he adds, provides something of a cushion through periods of market volatility.

While the First Sentier Geared Australian Share Fund was launched in 2023, over the firms’ 27-year history in gearing, Wilson says the strategy managed by the Australian Equities Growth team has done this successfully several times over.

“First Sentier Investors Australian Equities Growth team has run geared Australian share strategies incredibly durably since 1997. It’s experienced the dot com crash, the Global Financial Crisis, and particularly the COVID market meltdown,” he says.

The beginning of 2020, when the COVID-19 pandemic hit, was the ultimate test for the strategy, according to Wilson. The market fell 30% in 19 days, surpassing the previous record of 30% in 20 days seen in 1930.

“The geared strategy prevailed through that and was able to invest in quality companies through that period, which also provided opportunities coming into those stocks at that time as well,” Wilson explains.

“In that early phase of COVID when the market melted down quite quickly, we were able to manage the risks in that phase – we’re able to meet the margin calls because of the liquidity that equities operate with.

“I think it’s actually often underappreciated that equities provide a source of liquidity, and that source of liquidity allowed us to meet the margin calls as they occurred.” 

Any advice within this material has been prepared without taking account of the objectives, financial situation or needs of any particular person. Before acting on any advice, seek the advice of a registered financial adviser and consider the appropriateness of the advice having regard to your objectives, financial situation or needs.