Gearing to Grow- 14th August 2002

Peter Freeman - Bulletin

GEARING TO GROW

It has been a smooth ride for Australians who have utilised gearing over the past five years. Peter Freeman says even now, when global bourses are shaky, gearing can be profitable – as long as it's part of a clear, long-term strategy.




Australian investors have embraced gearing with unexpected enthusiasm over the past five years, in the process helping to provide significant additional impetus to both Australian share and property markets. It is a borrowing surge that has been driven mainly by three key forces: low interest rates, robust asset prices and a strong marketing drive by lenders and other intermediaries anxious to benefit from the growing appetite for gearing.

Aside from adventurous investors who borrowed to enter offshore sharemarkets, the results to date generally have been good. With residential property prices rising strongly in most major markets and the share prices of many of Australia's largest companies still holding up well, most people who have borrowed to invest have done well – at least on paper.

But what of the future? At the very least, it is likely the shakeout on Wall Street will have already undermined the confidence of some share investors. At the same time, the rising residential vacancy rates, especially for apartments, and the slow upward trend in interest rates may eventually provide a reality check for property investors who only saw the upside of their gearing strategy, not the risks.

The trouble is, just as rising asset prices created an atmosphere conducive to enthusiastic gearing, so the growing investment uncertainty could do the opposite. There is even a risk that a continuation of the Wall Street shakeout, if combined with the bursting of the boom in Australian real estate prices, will prompt a violent overreaction, with investors over the next few years deciding to avoid borrowing entirely. Precisely this sort of mood swing has occurred in the past. Unfortunately, the likelihood of it being repeated in the next few years is quite high.

This is the view of Peter Thornhill, head of Motivated Money, who says investors often do precisely the wrong thing when faced with major bull and bear markets. "People tend to overreact both on the way up and on the way down," says Thornhill, who is an expert on investor psychology. "The fact is no one should be surprised by the Wall Street correction, since it should never have risen so far so quickly in the first place." In his view, gearing actually makes more sense now than when sharemarkets were surging to what he says were "ridiculous" levels. The trouble is, he adds, most people don't see things that way and tend to rush to borrow to invest when markets are booming and then reject borrowing completely when markets correct.

"The main mistake is that people see gearing as an all-or-nothing strategy," says Thornhill. "This means they tend to borrow heavily in a boom and then not borrow at all when it busts." What they should do, he adds, is look to borrow "a bit" in most market conditions. This has the effect of adding a "kicker" to your returns when asset prices are rising but keeping your downside under control when times are more difficult. "In the case of shares, it is also sensible to borrow in instalments, so that you are adding on small amounts of borrowing gradually. This is especially true when markets are very volatile, as at present."

Justin McLaughlin, head of research at Bridges Personal Investment Services, has a similar view. While stressing that some investors almost certainly have geared too aggressively, especially in the property market, he says the coming decade will be a time when selective gearing will be essential to deliver reasonable returns. "We have been very defensive and haven't been recommending gearing to our clients for several years," says McLaughlin. "However, we are now telling people to get ready to start considering borrowing again ... not just yet, but fairly soon."

The main reason for the shift, he says, is that the era of double-digit returns is almost certainly past, with this decade likely to deliver no more than 7% or so on a diversified equities portfolio. "By adding in some gearing – say 20% or so – investors will be able to push this up closer to 10% without taking excessive risk," says McLaughlin. He stresses, however, that any gearing has to be seen as a long-term strategy, with the time horizon usually needing to be eight years or so. "You have to be able to be in the market long enough to benefit from upswings. If you have a short-term outlook, you shouldn't gear."

Both Thornhill and McLaughlin argue that investors should, whenever possible, use a home equity loan to finance their sharemarket gearing, not a margin loan. Whether or not a home equity loan is also the best option when gearing into an investment property will depend on individual circumstances. In particular, since a property investment is usually much larger than the outlay involved when gearing into shares, many people won't have sufficient equity in their homes to use this type of borrowing facility. Instead, they will need to take out a separate investment loan over the property being purchased.

It is indicative of the strong interest in investing in property that the latest Reserve Bank figures, which cover 2001, show 31% of the housing lending by banks was to investors, more than double that of a decade earlier. Nor is there any real sign of a drop in demand, at least not yet.

Warren O'Rourke, marketing manager with leading mortgage broking group, Mortgage Choice, says demand from home buyers and investors remains strong. "At this stage there aren't signs of a slowdown," he says. Nor, he adds, are people going on the defensive by opting for fixed-rate loans. "Given that rates are edging higher, it probably makes good sense to fix part of your loan and leave part floating, although it really depends on each investor's own financial situation."

Steve Davis, national manager (financial planning) with Perpetual Investments, says it is crucial for anyone considering gearing, whether into property or shares, to make a major effort to understand their personal financial circumstances, and then develop a clear investment strategy. "The gearing decision shouldn't really be influenced by the state of the market," he says. "It is not an issue of timing, of trying to jump on a bull market or picking the bottom during a slide, but of developing a steady, long-term approach to wealth creation that may or may not include gearing." He says people should go through a proper financial checklist before deciding to gear. Unless they do this, making the right decision becomes much more difficult.

While the checklist isn't the same for self-managed superannuation funds, mainly because these funds can't borrow directly, assessing whether to gear up these funds indirectly requires careful thought. One way to achieve this sort of gearing is to use a specialist equity fund that incorporates internal gearing. The approach of regulators is to allow super funds to hold these sorts of investments since they don't expose the investor to the risk of losing more than the actual cash amount outlaid. In contrast, any direct gearing – either through a margin loan or some form of standard investment loan – leaves the borrower facing the risk of not only losing the initial cash outlay but, if things go badly wrong, also being left with a debt for the amount borrowed and with assets that are now worth much less than the debt.

David Shirlow, head of technical at Macquarie Equities, says this situation is the main reason why Macquarie's Geared Growth Fund, which was launched early this year, is targeted at people running self-managed super funds. "Funds that have internal gearing can be used by anyone but they are particularly useful for superannuation funds," says Shirlow. "Of course, the trustees have to understand that an internally geared fund not only boosts their upside but also magnifies the slide if the market falls."

The other option for super funds centres on using instalment warrants, which, like internally geared funds, can be used by individual investors. Again, just like these specialist funds, the main benefit is the way these warrants restrict your risk to the amount of cash actually outlaid.

For those investors who want to borrow to buy shares but who are very risk-averse, there is the option of using a protected equity (also known as capital protected) loan. These are available from a range of lenders, including ANZ Bank, Leveraged Equities and Macquarie Bank. The key feature of these loans, which can be used to finance either shares or managed funds, is the way the investor, in return for paying a much higher interest rate, is protected against loss. If you borrow the whole amount invested and the value of the shares or funds you hold subsequently slumps, you will have the option of handing them back to the lender in full payment of the loan. The only cost to you will have been the relatively high interest rate you had to pay during the term of the loan. At present most cost about 14% to 16%, compared with about 6.5% on a home equity loan and 7.5% to 8% for a margin loan.

Richard Capel, senior financial planner with Arrive Wealth Management, says this cost is the main reason he doesn't support protected loans. "Most of my clients avoid gearing but some of the younger executives are more interested," says Capel. "If they are, I recommend a home equity loan, although some don't have that option. Even then, I don't advise using a protected loan because they have to achieve such a high return to cover the cost." This is the case even when account is taken of how such investors, due to being on the top marginal tax rate, can cut the after-tax cost of a protected loan to about 9%. If recent court decisions survive an Australian Taxation Office challenge, investors may be in a position to deduct the whole cost of these loans, not just 85%, which would often bring the net cost down to about 7%.

This means, however, that even after getting a tax deduction for the annual interest, investors still have a significant cash shortfall. Such negative gearing is fairly rare at the moment due to the low level of interest rates. In most cases, people using home equity loans have only a relatively small net cash loss each year, so their gearing is barely negative at all. This means that, provided interest rates don't rise very much, they don't need to get a great deal of capital gain to break even on their geared investments. Not so with protected loans.

According to McLaughlin, this means they are only suitable for those times when asset prices are rising strongly. "In a bull market, both the potential gains and risks are high," he says. "Taking out protection in that situation makes reasonable sense. It is much less sensible in the current investment climate."


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