Many people establish an SMSF solely to purchase direct property, often borrowing from a bank to complete the transaction. The approach of borrowing a significant amount of money is widely recognised and accepted, within both an SMSF and personal investment strategies
However, borrowing to invest (also called gearing or leveraging) in shares carries a completely different perception. It evokes memories of the global financial crisis and the rapid erosion of wealth over a matter of months.
While the tangible nature of property is an obvious advantage, investors may be overlooking the return potential that gearing into shares could offer. Historically, shares have outperformed property on a dollar-for-dollar basis, yet property often appears more attractive due to the easier access to borrowed funds for amplifying returns.
Borrowing to invest in any asset class extends the necessary investment timeframe. This is precisely why superannuation could be an ideal environment for geared investments, given the legislated access ages, provided the investor starts early enough.
This article will examine the benefits and potential drawbacks of a gearing strategy within superannuation. For the purpose of this discussion, it will be assumed that an SMSF is used, as these investments are not currently available through industry fund direct investment platforms. Wrap platforms have also been excluded due to their long-term cost inefficiency and the requirement to engage a financial adviser. While some retail superannuation funds do offer geared investment options, they tend to be expensive, lack diversification within a single fund, and employ relatively high levels of leverage.
Borrowing for Shares
It is far more difficult to borrow money to invest in shares than it is for property. The closest equivalent to a standard mortgage is a margin loan.
Margin Loan
A margin loan uses shares as security for the loan, much like a mortgage uses property.
However, margin loans come with several issues. The first is margin calls. If the value of the shares used as security falls below a certain level, you may be required to sell down holdings or contribute additional funds. This happens because margin lenders impose a maximum loan-to-value (LVR) ratio. If a decline in share prices pushes your LVR too high, a margin call is triggered.
The second major issue is high interest rates. Margin loan rates are typically 3-4% higher than standard mortgage rates. Higher interest costs mean you need to achieve a higher return just to break even. With margin loan rates currently around 8.5% and long-term share market returns only slightly higher, the case for margin lending is weak. While interest costs are generally tax-deductible, the benefit is particularly limited in superannuation, where the deduction only offsets 15% tax.
Margin lending within superannuation is rarely appealing, particularly for long-term investors. The high interest costs and minimal tax benefits erode returns. Additionally, finding a lender willing to offer a margin loan within an SMSF is difficult due to limited recourse borrowing requirements.
Internally Geared Funds
The only practical way to access leverage for share investments within an SMSF is through internally geared funds. These funds borrow money at the fund level and invest it on behalf of investors. They are available as managed funds or exchange-traded funds (ETFs), which can be purchased through brokers like CommSec or Stake.
Internally geared funds have been around for some time, but their reputation took a hit during the global financial crisis. Many highly geared products collapsed, leading to significant losses for investors.
The level of gearing (debt) determines how much additional market exposure an investor gets. For example, a gearing multiple of 1.5x means that if the share market rises 10%, the fund increases by 15%. Historically, some funds had gearing as high as 3x, meaning a 10% gain in the market translated to a 30% rise. However, the same applies in reverse, if the market fell 20%, a 3x geared fund would lose 60%. This extreme volatility made highly geared funds popular before the GFC, but disastrous for investors when markets eventually crashed. As a result, most people remain wary of using these products for long-term holding.
That said, these past failures do not mean gearing cannot be beneficial when applied in a more measured way. Recently, there has been a shift towards well-diversified funds with lower gearing, typically around 1.5x. At this level, a 10% market drop results in a 15% decline. Not ideal, but far less severe than the higher-geared alternatives.
For those starting early, this moderate level of gearing has the potential to significantly improve retirement outcomes. Superannuation is a long-term investment by design, with access generally restricted until at least age 60. This structure naturally supports a longer investment horizon, making it a suitable environment for a measured gearing strategy.
Potential Benefits when used in Super
Before considering geared investments in superannuation, it is crucial to understand that borrowing to invest is a high-risk strategy. While debt can magnify returns, it also amplifies losses. As a general rule, gearing is considered very risky for anyone with less than 15-20 years until retirement. Seeking financial advice before using these products is essential.
Magnified Returns
The primary reason investors use borrowed money is to enhance returns. Theoretically, a 1.5x geared fund should generate 50% higher returns over the long term (before interest costs) compared to an ungeared equivalent.
The following projection illustrates how this could impact a couple’s retirement savings. It compares two scenarios:
- Each person investing in a standard industry fund index option.
- Using a 1.5x geared fund within an SMSF.
An SMSF is used in the comparison despite these funds also being available through wrap accounts, as wraps typically require an adviser and can be more costly at higher balances.
Key assumptions are outlined below:
- The projection period is 30 years, reflecting a typical accumulation phase within superannuation.
- The geared fund’s annual return is conservatively estimated at 1.25x the market return, accounting for internal borrowing costs.
- All figures are indexed to inflation, meaning they are presented in today’s dollars.
- Administration & brokerage fees are based on those used in a previous analysis of industry funds versus SMSFs.
- Geared funds have higher investment fees than their index fund equivalents.
- Contributions are based on a couple, each earning $100,000 per year, indexed to inflation.
- The geared fund within the SMSF grows to approximately $3,950,000.
- The industry fund option results in a combined balance of $2,650,000.
This represents a 50% higher balance in retirement, despite the higher fixed costs of the SMSF in the early years.
The reason for this 50% increase, despite the gearing effect being 1.3x rather than 1.5x, is due to compounding. Over long periods, the compounding effect significantly enhances outcomes.
It should go without saying, but the projection above does not account for the additional volatility of the geared option as this is completely impossible to predict or model in any way.
No Margin Calls
One of the biggest risks of borrowing to invest is the possibility of a margin call, where falling asset values force investors to sell holdings at an inopportune time.
With an internally geared fund, investors do not personally hold the debt, so margin calls do not apply. While the fund itself may adjust holdings to maintain its internal gearing ratio, this is reflected as price volatility rather than a forced sale for individual investors. This key difference makes internally geared funds far less risky than margin loans.
Lower Borrowing Costs
Another major drawback of margin loans is their high interest rates, which eat into returns. Internally geared funds mitigate this by borrowing at wholesale interest rates, which are significantly lower than standard margin lending rates.
Currently, these funds borrow at around 5-6%, similar to or even lower than standard home loan rates. This makes the cost of borrowing much less impactful upon end returns.
Ability to Rollover CGT
A major advantage of SMSFs is the ability to transition unrealised capital gains from accumulation phase to pension phase, where no capital gains tax (CGT) applies.
For long-term investments, particularly geared funds with higher expected growth, this can be a significant tax benefit. If held throughout an investor’s entire working life, accrued capital gains from years or decades of accumulation could effectively be taxed at 0% upon retirement.
Consistent Investments
A geared investment being used within super could perhaps be considered the most ideal application of the product. Unlike personally held investing, superannuation has constant contributions and therefore, investments being made on a regular basis.
Ongoing personal investments depend highly on free cashflow being available. During periods of market downturn, the economy is less likely to be strong and therefore, free cashflow may not be as plentiful as it once was. This is an issue, because buying when investments are depressed will further multiply returns over time. This is a phenomenon that we have previously covered.
Compare this to super, where contributions must be made directly by your employer each time you get paid. Provided that you maintain your job, you will still be investing whilst your assets are depressed, further multiplying your investments over time.
Potential Downsides
The most significant downside of a gearing strategy is increased volatility. Investors must be comfortable with the potential for large market declines, which are almost certain to occur over a 20-30 year investment period.
Beyond volatility, there are other potential drawbacks to consider:
Loss of Direct Deductions
Unlike margin lending, internally geared funds do not provide direct tax deductions for the interest payable on borrowed money.
However, the impact of this is somewhat mitigated for two reasons:
- The tax advantage within super is limited: At most, the tax benefit of deducting interest in super is 15%, far lower than in personal investment accounts.
- Interest costs offset distributions: Internally geared funds often reduce taxable distributions because interest expenses are deducted at the fund level. This means a lower taxable income for the SMSF itself, essentially creating a tax deduction.
Theoretically there could be a situation where the interest costs exceed the gross distribution. As trusts (the investment fund itself) cannot distribute losses this tax benefit may be lost. However, this would likely be a rare situation.
No Ability to Reduce Leverage Without Selling
Because the debt is held within the fund, investors cannot control their level of leverage. Unlike a personal loan or margin loan, where debt can be repaid to reduce risk, an internally geared fund does not allow for deleveraging.
The only way to remove leverage is to sell the investment and switch to an ungeared option, which may have tax consequences depending on when it is done.
Volatility Decay
Volatility decay refers to the fact that large losses require disproportionately larger gains to recover. If an investment falls 50%, it takes a 100% gain just to get back to even.
With leverage, this effect is amplified. A 1.5x geared fund would fall 15% if the market dropped 10%, requiring 30% to get back even. This is often cited as a reason against using geared funds, but the argument is usually overblown.
- Yes, leveraged investments experience larger drops.
- But they also experience larger gains during recoveries.
There is an argument that in very highly geared funds this is more of an issue. Consider a 3x leveraged investment where the market drops more than 33%, theoretically causing the fund value to be zero. In reality, this is unlikely due to:
- Market volatility limits that prevent extreme daily movements.
- Most geared funds reset their level of gearing daily, reducing the risk of total loss.
For a deeper perspective into the potential impact of volatility decay being exaggerated, this paper is a good start: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1664823
Conclusion
It’s worth repeating – leveraged investment funds carry significantly higher risk than conventional investments. However, using them within superannuation may help manage some of these risks due to the inherently long-term nature of super, provided the investment starts early enough. At present, accessing these low-cost, moderately geared funds requires an SMSF or a wrap account, both of which generally need a certain level of assets to be cost-effective, along with additional administrative responsibilities.
Borrowing for shares still has a reputation, largely borne from collapses in the GFC. It is interesting though to note the willingness of Australians to take on significant debt for property whilst holding a relative apprehension toward shares, even unleveraged ones. Of course, property is generally seen as less volatile, but its level of gearing is minimal compared to the highly leveraged funds referenced. Buying property with a 20% deposit effectively provides a 4x exposure to the property market. This is compared to moderately geared share funds which are around 1.5x.
Moving past this stigma and toward new, low-cost, and moderately geared investment options could be an opportunity to enhance superannuation returns. While not suitable for everyone, the additional returns provided by a well-diversified, geared investment fund over very long periods of time could lead to a significantly different retirement outcome.
Given the complexity and potential risks, leveraging through an SMSF is not something to be undertaken lightly. Therefore, consulting with an appropriately qualified financial adviser should be the first step when considering such investments.
