Is a ‘one-click’ gearing strategy into shares right for you?

If you’re an aggressive investor who is comfortable with extra volatility, an internally geared Australian (or overseas) share fund might be worth looking at.

Sometimes referred to as “a one-click gearing strategy”, internally geared share funds offer a no-fuss alternative way to leverage into shares.

What these funds actually do is manage the geared exposure for you, without the lingering threat of margin calls that come with borrowing from a bank or broker.

How internally geared share funds operate?

Pitched as an easier way to pursue a geared investment strategy, specialist internally geared share funds have a structure within which internal borrowings average around 25% to 50% of the total fund.

This is then used by the manager as an extra source of finance to acquire more investments on your behalf.

One of the pioneering funds in this space was the Colonial First State Geared Australian fund, and since the early 2000s a swag of similarly geared share funds and ETFs have joined the party, including Ausbil’s Australian Geared Equity Fund.

Broader market access: lower costs

While most internally geared funds are actively managed, these products simply provide exposure to the broader market at lower cost.

Internally geared share funds typically borrow on behalf of investors at wholesale interest rates, which can be significantly lower than what you could access yourself.

All things being equal, an internally geared share fund has the potential to significantly outperform (or underperform) its ungeared counterpart, and the higher the gearing, the more volatility you’d expect to see in the unit price.

The workings

How an internally geared share fund works in practice is relatively simple.

Let’s assume you invest $50,000 in an internally geared share fund via a unit trust, which borrows at a wholesale interest rate of 6% annually, to which the geared share fund adds another $15,000 of borrowed money.

Your total investment is now $65,000, with a modest gearing ratio of 23% (i.e. $15,000 / $65,000 x 100).

Net result is for every $1 invested in the fund you now have $1.30 worth of exposure.

Limited recourse

The returns of shares geared with a margin loan behave exactly the same as those of a geared share fund, but there’s one key exception.

Unlike margin loans, an internally geared share fund is generally what’s known as “limited recourse”.

This means if the investments fall in value below the level of fund borrowings, you’re not required to pay back the shortfall to the lending institution.

The most you can lose with these investments is your initial capital outlay, and this could save you from losing your shirt if things turn to custard.

Shortcomings

Despite the many attractive features on offer–less paperwork, no credit checks, lower costs – internally geared products have one very significant drawback.

They can be far less tax effective.

For example, investors in an internally geared share fund will be unable to pay the interest upfront and claim it against their marginal tax rate like a margin loan.

But while internally geared funds may not give you an immediate tax deduction, this will be irrelevant when the market experiences a normal sell-off and geared strategies produce losses potentially exceeding 50%.

Not for the faint hearted

Putting the pros and cons of internally geared funds to one side, the bigger issue for investors’ will always be around getting the timing right.

While recent history shows the power of gearing in rising markets, it also shows the drag within relatively flat ones in which gearing tends to deliver a negative return.

Given that it can decimate your wealth permanently, you must consider the outlook for the market and current valuations.

Bottom line is when the market is looking fully valued, gearing can be a more dangerous strategy. Given that the market is currently bleeding value, now's an opportune time to assess your options.

Internally geared ETFs to check out

BetaShares Geared Australian Equity Fund (hedge fund) (ASX: GEAR): Provides geared long exposure to the returns of the Australian share market (as measured by the S&P/ASX 200 Accumulation Index).

GEAR share price performance over 12 months.

The BetaShares Australian Equities Strong Bear Hedge Fund (ASX: BBOZ): Provides geared short (or negatively-correlated) exposure to the returns of the Australian share market (as measured by S&P/ASX 200 Accumulation Index).

BBOZ share price over 12 months.

BetaShares US Equities Strong Bear Hedge Fund – Currency Hedged (ASX: BBUS): Provides geared short (or negatively-correlated) exposure to the returns of the US share market (as measured by the S&P 500 Total Return Index).

BBUS share price over 12 months.