Geared share funds are high risk and high reward. When share markets are doing well, the returns can be very high, but the opposite is also true. We look at the pros and cons, and the role of geared share funds in a diversified investment strategy.

Geared share funds can be a great way for investors to invest in shares – and share in the rewards – when the share market performs well over long periods of time.

Geared share funds magnify both positive and negative returns, so they’re considered high risk, high return investment options.

But exactly what is a geared share fund, and are they for everyone?

Let’s take a look at the ins and outs of this unique investment option.

What is a geared share fund?

Geared share funds accept money from investors and borrow money to invest alongside investors’ capital. The fund uses the pool of investors’ money and borrowed money to buy shares.

They amplify both positive returns and negative returns on the shares in which the fund invests.

On the upside, geared share funds generate higher returns than overall share market returns when markets are rising. Conversely, the value of your investment will drop further than equivalent investment options without internal gearing.

They are best explored as part of a long term, diversified investment strategy.

How do geared share funds work?

When you invest money in a geared share fund, the fund will borrow money to invest on your behalf, alongside your investment.

For example, for every $1,000 you invest in the fund, the geared share fund may borrow another $1,000. That would give you $2,000 of exposure to the shares in which the fund invests. So in addition to the returns generated from your capital, you also receive all the returns from the borrowed funds (less the cost of borrowing).

The fund’s gearing, or borrowing, effectively magnifies the returns of the underlying investments, whether they are gains or losses.

Geared share funds generally perform well when the share market is growing at a higher rate than the interest charged on borrowed money.

Geared share funds borrow at institutional interest rates, which are generally lower than those offered to individual investors.

Pros of geared share funds

• The gearing, or borrowing, is done within the fund: unlike a margin loan, the fund, rather than the investor, is responsible for repaying its loans. This model allows investors to keep a long term view on their investments, rather than worry about day to day performance of their investments.
• Investor exposure is limited to their invested capital: while the fund borrows on behalf of its investors to buy shares, if the share market falls, and the fund’s loans need to be repaid, individual investors will never lose more than their invested capital.
• Gains are magnified by gearing: when the shares in which the fund invests go up, the return to the investor may be much higher than if they had simply purchased an equivalent fund without gearing.
• Franking credits are magnified by gearing: when a geared fund invests in Australian shares, the gearing will also magnify the level of franking credits payable as part of income distributions.
• Long term gains magnify long term share performance: investors seeking to invest for a decade or more, and who are willing to ride out short term market falls, can do very well with geared share funds. The compounding effect of the additional returns from gearing is very powerful over the long term.

Cons of geared share funds

• Fees are relatively high: fees are charged not just on the $1,000 you invest, but also on the $1,000 that the fund borrows on your behalf. Fees reduce your return.
• Losses are magnified by gearing: when the shares in which the fund invests go down, losses will be much higher than if you simply purchased the same shares with the same initial investment.
• Short term share market falls can lead to big investment losses: investors who need to take out their capital at a particular point in time, or who are not prepared to wait for markets to recover, can suffer big losses if this coincides with a fall in markets.

When to consider geared share funds

Geared funds can play an important role within a diversified portfolio for investors looking for above average investment performance over the long term by accelerating their Australian and/or global share allocations.

Investors who can ride out short term market volatility and do not need to take out their money in the short term, may benefit from the long term returns that geared share funds can offer. Geared funds should therefore be particularly attractive to superannuation investors who cannot access their capital until retirement.

Investors who are risk averse and who may need to cash in their investment in the short term, may not find geared share funds a suitable investment.

Investors should always seek financial advice to ensure investments are suitable for their objectives, investment horizon, and personal circumstances.

Source: CFS