Summary: A geared share portfolio can become self-funding over time if dividend income exceeds the loan interest costs. But there are no guarantees, and borrowing to invests means you are forgoing defensive assets in your portfolio.

Key take-out: The essential feature of gearing is to have a long-term strategy….at least five years.

How quickly the tide turns? Suddenly the sharemarket has jumped by 8% in the first few weeks of the year, and home prices are lifting too (if ever so gently).

Under ‘normal’ circumstances you would expect a large number of investors to have ‘geared’ – that is, to have borrowed in some way to finance their investments.

These are hardly normal times, but hopefully we are returning to a new normal where investors behave in a somewhat rational way based on improving fundamentals. Certainly there is some early evidence that gearing activity in the market, though clearly at subdued levels, is lifting.

With markets breaking through the 5,000 point barrier, and a generally more positive mood around the sharemarket, a question that is worth considering is whether now might be the right time to borrow to invest – to gear into the market.

In today’s Eureka Report, myself and two colleagues attempt to re-open the issue of gearing. Bruce Brammall examines the current trends in DIY superannuation, and Tony Rumble introduces and reviews a number of new gearing products that have entered the market since the GFC obliterated gearing as an investment strategy for an extended period of time. This article explains how gearing actually works and how it clearly boosts returns when used effectively.

Gearing has long been a favourite strategy of the financial services industry. Encouraging people to borrow increases the fees the industry can make (brokerage fees, managed fund fees, fees from the loan). It also increases the possible upside for investors as well as the potential downside – as seen by people who had borrowed to invest, losing everything in the collapses of Storm Financial and Opes Prime.

However, one of the issues facing investors in the recharged atmosphere of a healthier stockmarket is the range of gearing products has flourished. Indeed the once ubiquitous business of ‘margin lending’ has not returned to the fore and it may be the case that a new generation of geared investors will not find margin lending appropriate for their purposes. Moreover, the poor reputation this sort of financing acquired in relation to various collapsed schemes in recent years may have scared off many people for good.

To look at this question, let’s start from the position that margin loans are not a great way to borrow money. They are usually expensive loans and they can lead to the forced selling of assets if markets fall. Instead, let’s assume that ability to borrow some money against the value of a property.

A gearing strategy has to be considered over a reasonable timeframe, so let’s take a five-year view. In reality, I think your timeframe should be much longer than five years, however this gives us a starting point to consider options.

UBank (a NAB company) has a five-year fixed rate loan for 5.61% pa. The point of using a fixed loan is that we know exactly what our interest repayments are for the five years, and can compare this against the dividends and investment returns we would need to have a successful investment. Our calculations and strategy will not be derailed if borrowing rates spike to 9% in 3½ years’ time.

Assuming that we are going to borrow $200,000 for the share portfolio, we know that the interest repayments over the five years will be $11,220 a year (5.61%).

Considering the dividends

Currently the sharemarket is providing an average yield of 4.2% (although it is hard to get an exact measure – just like with price earnings ratios, there is a variety of figures). Indeed the average yield for the market was closer to 5% quite recently, however with the sudden surge in stock prices the average yield figure for the ASX top 50 has slid to 4.4% and for the ASX 200 it is 4.2%.Obvioulsy, a selected portfolio that was top heavy with banks, Australian Real Estate Investment Trusts and high dividend payers such as Telstra and some utilities would take us back around 5%.

But let’s be very conservative and assume the market stays at least at the elevated levels it has already achieved, allowing for the fact it has already risen by around 8% this year. Sticking with even a 4.4% average dividend yield, that means the $200,000 will pay us cash of $8,400. We will also receive some franking credits, which are just as good as cash for an Australian investor. Assuming the portfolio produces franking at around the 70% fully franked average level, that will be a further $2,520 in effective income – total income of $10,920.

That means the portfolio goes awfully close to funding itself – a shortfall (interest costs – income earned) of only $300 a year – or $6 a week. That’s a cup of coffee a week, provided you get your coffee at a more upmarket establishment.

One of the great benefits of the income from shares is that it tends to grow over time. If we make a conservative assumption (compared to the long-term increase in dividends) that this income grows at the rate of inflation of 3% a year, by the second year the portfolio is making $11,248 in income – more than the cost of borrowing. By the fifth year the cost of borrowing is still $11,220 and the income will have increased to $12,291.

The following graph shows the yearly interest payments $11,220 (red bars) against the increasing dividend income.



The bottom line is this – to be successful in this scenario what you need is for the shares to go up over the five-year periods. Any gain in share price will put you ahead. Of course, this is not a given. There are periods of negative share price returns over five years.

Even though this analysis seems largely attractive – your cost of borrowing and your expected dividends are about the same, so all you need is for the shares to appreciate in value to have a successful investment experience – there are other factors you should consider.

Forgoing defensive assets

Defensive assets like cash and fixed-interest investments have important roles in portfolios, including providing liquidity (easy access to cash), reducing the volatility in a portfolio and allowing an investor to take advantage of buying opportunities when markets fall.

When you borrow to invest, because the cost of borrowing money (in this case 5.61%) is higher than what can be earned by investing in cash and fixed-interest investments, it makes no sense to have these investments – money is better used to pay off the loan. (This logic holds after tax as well, because even though the interest on the loan is a tax deduction the interest earned on a bank deposit or fixed interest investment is taxed).

So, if an investor likes having defensive assets in a portfolio they are unlikely to feel as comfortable with a gearing approach.

Market timing humility

Gearing becomes an aggressive market timing strategy. If you pick a great time to invest, then your returns will be sensational. If you pick a bad time, it could be ages until you can afford a $6 coffee again. On that basis, it is well worth being a little humble and saying that the time to start a gearing strategy would have been in March 2009, four years ago. Since then markets are up more than 60%, plus you would have received dividends equal to around 25% of your starting portfolio. That would have been a great time to invest. Unfortunately, I didn’t put $200,000 into the market then and I don’t know many people who did. Given we missed this awesome opportunity, perhaps we should now be more humble about throwing a lot of our financial assets into the one basket.

Conclusion

There is certainly a buzz around the sharemarket at the moment. The thought of borrowing to invest in shares and winning big is tempting – and certainly the cash flow calculations that show all you would need is for the market to increase in value over the next five years to make money suggests that it is a strategy worthy of consideration.

However, future returns are not guaranteed – even over a five-year period. Borrowing to invests means that you are forgoing defensive assets in your portfolio (as both before and after tax they will earn a return less than the cost of borrowing) and the benefits that they provide in liquidity, dampening volatility and giving you access to cash if buying opportunities present themselves.

And lastly, we should never be too confident about trying to time a large entry into the market. If we were all that good, we would have geared up four years ago and be enjoying the success of our strategy now.