Geared ETFs: When could they make sense for your portfolio?

Australians are quite familiar with the use of gearing or leverage when it comes to building wealth.

For example, every single Australian with a mortgage over a property technically uses borrowed funds to grow their wealth.

This strategy has proven to be the cornerstone of wealth creation for many Australians provided that the value of the property increases in value by more than the cost of borrowing.

However, with property becoming further out of reach for more Australians, can the same strategy be used for other assets? The answer is yes.

Understanding geared ETFs

Geared exchange traded funds (ETFs) are investment funds that use leverage to magnify the returns of an underlying index. For example, a geared ETF might aim to deliver twice the daily return of the S&P/ASX 200 Index.

If the index rises 1% in a day, the ETF will aim to rise 2%. Conversely, if the index falls 1%, the ETF will fall 2%.

When it comes to ETFs, gearing is managed internally by the fund, meaning investors do not need to borrow directly or manage margin loans.

The fund combines investor capital with borrowed funds, typically at very competitive institutional interest rates, and invests the proceeds in a diversified portfolio of equities. The gearing ratio is actively monitored and adjusted to stay within a target range.

What is the appeal of gearing?

The primary appeal of geared ETFs lies in their ability to amplify returns. Over long investment horizons, even modest leverage can significantly boost portfolio growth, provided markets trend upward.

Geared ETFs also offer a more accessible way to use leverage compared to traditional margin loans. Investors don't need to borrow directly or manage loan repayments.

Instead, the fund handles the gearing internally, at institutional interest rates, and investors simply buy and hold units as they would with any other ETF.

The case for moderately geared ETFs

While gearing in principle has provided a clear pathway to building wealth outside property, the associated volatility can be a deterrent to some investors.

It's why Betashares launched a range of moderately geared ETFs. These funds aim to provide a gearing ratio of around 30-40%, offering a balance between enhanced return potential and reduced volatility.

The Wealth Builder series, including ETFs with underlying exposure to the largest 200 companies on the ASX, the Nasdaq too, and broad diversified equity exposures covering multiple markets, is designed for investors with a long-term focus who want to benefit from gearing without taking on the higher risk associated with more aggressive leverage.

This approach could be particularly relevant for self-managed super funds (SMSFs) and long-term investors who want to benefit from gearing without taking on the higher risk associated with higher levels of leverage.

By limiting the gearing level, these ETFs aim to reduce the volatility drag that can occur with daily rebalancing and make them more suitable for longer holding periods.

Combining gearing with dollar cost averaging

When starting with little investable capital, achieving your financial goals can seem a long way off. Geared ETFs can potentially accelerate the accumulation process.

However, the use of gearing can result in significant capital erosion should you encounter a market correction. One way to mitigate this risk is to invest using a dollar cost averaging (DCA) approach.

Provided you invest consistently, preferably with zero brokerage, and the market generally appreciates by more than your cost of borrowing over the long run, investing using a DCA approach could allow an investor to take further advantage of the market's compounding power.

Potential for enhanced franking credits

By investing in a geared ETF that provides exposure to Australian shares, you may receive more dividend income and be entitled to more franking credits than if you had invested in an equivalent ungeared portfolio.

Those franking credits may be used to offset other tax payable or generate a tax refund, depending on an investor's particular circumstances.

Optimising outcomes inside super

Building wealth and generating income inside superannuation can be advantageous from a tax perspective.

Where consistent with an SMSF's investment strategy and risk tolerance, moderately geared ETFs can be used in a number of ways inside an SMSF. For example:

• Wealth Builder ETFs can make super contributions work harder, by providing approximately $45,000 of exposure to equity markets for $30,000 of invested capital (being the concessional contributions cap effective from 1 July 2024).
• For super fund balances at or near proposed thresholds, moderately geared ETFs can provide scope for a SMSF to enhance franking credits and the ability to buy or sell units on the ASX for more flexible cash flow management.
• Individuals in pension phase who wish to retain a specific level of investment exposure to the equity market can potentially boost their pension income payments by investing in a moderately geared ETF in combination with a lifetime annuity.

At the end of the day, investors should do their own homework, but moderately geared ETFs can help investors improve their long-term wealth outcomes by applying the familiar concepts of leverage to a broad equity portfolio.

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