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 Is share gearing worth it? - Eureka Report article 

August 27, 2008

 

Is share gearing worth it?
By Scott Francis

 

PORTFOLIO POINT: A geared share portfolio will increase returns, but at the risk of much greater volatility.

It's an attractive come-on from banks and brokers: "Over the long term, gearing into shares turbo-charges your returns". Attractive, sure, but is it true?

Certainly we know that over the past few months gearing into shares can turbo-charge your losses. With the ASX down 21% this year to date "geared" investors will be suffering badly as the value of their losses are magnified by borrowing, and still they must keep paying their borrowing fees.

But maybe things are better over the long term. Let's find out.

Measuring portfolio risk

In most cases the "risk" of a portfolio is measured by the "standard deviation" of returns. While standard deviation is somewhat of a statistical weasel word, what it does is measure the spread of returns. The higher the standard deviation, the greater the spread of investment returns.

In practice, about two-thirds of all returns end up within one standard deviation of the average return. So, if a portfolio has an average return of 10% and a standard deviation of returns of 10%, then 66% of the returns will be between 0% and 20%. About 14% of the time the return will be below 0% and a similar amount of the time above 20%.

What impact does borrowing to invest have on ?risk'?

I've put together a model of historical sharemarket returns and borrowing costs to see what sort of long-term returns are derived from the strategy of borrowing to invest. The key assumptions I have made include that:
  • Sharemarket returns are expected to be equal to the market average return. (Even though most investors expect that they are going to get an above market average return, research (eg, managed fund research, analyst recommendation research, investor portfolio research) shows this is unlikely).
  • Borrowing costs are equal to the cash rate plus 2% (in reality most margin loans are more expensive than this, closer to 3% above the cash rate).
  • Each year's return is independently calculated.
  • The reported return is the simple average annual return each year.
  • All data is for the period from July 1, 1970, through to June 30, 2008.

Over that period (July 1970 to June 2008) the average investor in a cash investment received a return of 9.39% with a standard deviation of returns of 4.47%. The volatility in returns came about as returns fluctuated from 18.5% (1990) to 4.7% (2002).

If you invested in a portfolio made up of 50% cash and 50% shares, the return you received would be 11.24% with a standard deviation of returns of 10.93%. There is an increase in both the average return and the standard deviation of returns.

If the portfolio is 30% cash and 70% shares, the return increases to 11.98% with a standard deviation of returns of 14.69%.

For a 100% Australian share portfolio, the average return is 13.09% with the standard volatility of returns being 20.51%. In other words, if you move from total cash to total shares your returns move from an annual average of 9.39% to 13.09% but your volatility effectively quadruples from 4.47% to 20.51%.

And that's before you even introduce the notion of borrowing (or gearing). Once you do that the volatility rockets . but the extra returns grow ever more slowly.

Once you start to borrow, there is a sharp increase in the volatility of the portfolio. For example, a 50% loan to value ratio sees returns increase by 1.7% to 14.78%, with portfolio volatility increasing to 40.35%.

In other words, for enduring a doubling of volatility, you get just 1.7% in extra returns.

A more aggressive loan to value ratio of 66% sees returns increase to 16.47%; while portfolio volatility increases to 60.36%.

The following table sets out the degree to which borrowing to invest increases the volatility of a portfolio:


All this seems to bring into sharp focus the increased volatility that borrowing to invest creates. Things become even more marginal when we take a fee of 1% off the average annual return for Australian shares.




Tax benefits of borrowing to invest

There are two tax benefits of borrowing to invest in Australian shares:

  • You receive franking credits from the Australian shares that offset your tax payable.
  • If the income from the shares is less that the investment fees and the interest cost of borrowing, this can reduce your overall taxable income through negative gearing.

A couple of moderating comments. The first is that many people's tax rate has dropped, with the top tax rate only applying to income above $180,000.

The second is that if you borrow to invest through managed funds, many of them have very high rates of distributed capital gains making them tax-ineffective, and reducing or completely eliminating the negative gearing impact.

A recent sample of large managed funds (see Big-name funds disappoint) found that large managed funds had distributions of about 15.5%. This would have left investors using the strategy of borrowing to invest having to pay tax, rather than reduce their tax.

More generally, managed funds do not suit gearing as well as direct shares because, overall, managed fund capital growth returns are rarely as high as direct shares - primarily due to management fees, distributions of capital gains and occasionally due to poor management judgment.

Do investors ever need to take on this risk?

A key question around borrowing to invest is whether people need to take on the extra risk (volatility) of borrowing to invest to meet their financial goals? The strategy of looking to invest regularly over time is a sound alternative, as Alan Kohler outlined in his most recent column (see The best of times and the worst of times). Further, it allows investors to take advantage of lower investment values that the current market presents, by investing regularly at cheaper levels.

A compromise between these two options - investing surplus income regularly and borrowing to invest - is a regular gearing strategy, where regular investments are supplemented with borrowed money.

The model outlined earlier presumed the investor took a large lump sum at the start of the gearing exercise. This alternative model assumed the investors borrows invests and borrows incrementally.

The industry bias

It does not matter whether you are talking about a financial planner, stock broker or fund manager; almost certainly a larger the portfolio will mean bigger fees. Not only will they receive a greater fee from your investment portfolio, there is a chance that they will also pick up a trailing commission from the margin loan that they recommend. This could be said to influence the "conventional wisdom" of the financial services industry to over-promote the strategy of borrowing to invest.

While the industry points out that "borrowing magnifies both the returns and losses of a portfolio", are clients told that during a 1974-style market downturn a 66% geared portfolio would have lost all of an investors contributed money, and that during the 1982 downturn even a 50% geared portfolio would have lost just over 80% of an investors contributed funds?

Remember the adviser's commission is based on the total amount invested; the portion of the total that is borrowed may be of little concern to either the adviser or the lender

Conclusion

Borrowing to invest remains a legitimate way of increasing the expected return of a portfolio, offering investors tax benefits, but these higher returns come at the cost of significantly increased portfolio volatility. Investors should be aware of this cost, the bias the financial services industry has toward borrowing to invest and the power of the simpler strategy of investing regularly over time in growth assets while building a passive income stream. They should consider all this before deciding whether the risk of borrowing to invest suits their situation.

Scott Francis' articles in the Eureka Report 

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