Australia, Capital Markets, Funds Management, Personal Finance - Written by Chris Wright on Wednesday, June 1, 2011 8:44 - 0 Comments
AFR ETF series: gearing
Smart Money, Australian Financial Review, June 2011
Exchange-traded funds (ETFs) are increasingly turning up on the menus of margin lenders, contracts for difference (CFD) platforms and leveraged structured products. It’s becoming easier than ever to gear into an ETF: to borrow to invest, and to magnify the results of your investment, for better or worse.
When you think about it, if you like the idea of gearing then doing so through an ETF makes a certain amount of sense. Gearing always carries some risk, and that risk is concentrated if you have put all your eggs in one basket, such as by putting all your leverage into one share. Spreading the risk around is common investment practice, and ETFs represent among the easiest and cheapest ways of diversifying, since you buy and sell them like any other share but they represent a whole asset class like a stock market.
“Gearing is a pretty hot topic,” says Amanda Skelly from Russell Investments. “We’re getting a lot of requests from advisers and investors around gearing strategies for ETFs. Using an ETF as the underlying for a gearing strategy is a really good foundation investors can build around, because it’s diversified. Many investors look to use it as an anchor for their portfolio, and take the leverage from that to buy an active fund or a hot stock as a complementary position around that anchor.”
Margin loans are an obvious way of gearing into ETFs. You take a loan, it is secured against your investments, and you are permitted a certain amount of leverage. For example, with a 50% geared margin loan, you get twice as much exposure as the money you have put in yourself (in other words, half the investment is what you put in, half is the loan). It’s always important to remember that if the value of your investment falls, then your loan to value ratio will change; once the loan’s proportion of your investment passes a certain point (often 70%), you will be subject to a margin call, which will require you to put in more money or sell down your investment. For this reason, it’s always sensible to keep your gearing within manageable limits.
CFDs increasingly include ETFs too, and these can permit much higher levels of gearing: sometimes as much as 20 times. They are not, though, the most common method of getting access to ETFs, and investors should exercise great caution with very high gearing levels. At a minimum they should familiarise themselves with stop losses, which close out a trade before you can lose too much money on it.
There is also a third, growing area of leveraging into ETFs, and that is the self-funded instalment warrant. Issuers like Westpac and Citi have revived these once-popular structures since the financial crisis, finding that investors like their simplicity and relatively low risk. Instalments involve you buying a share in two instalments, one at the outset, and the other at some pre-agreed point in the future. The good thing about them is that once you’ve made your first instalment, you get the full dividends and franking credits.
In a self-funding warrant, you receive a loan to make your second instalment, and the warrant uses your dividend to meet the interest payments on that loan and hopefully pay it down too. In an ideal world, by the time you pay off the loan and take full ownership of the stock, it will also have increased in value. If it’s gone the other way, you can walk away from the investment.
ETF issuers and self-funding instalment providers have started joining forces. A recent example was Citi and Russell launching a combined product called the CitiFirst SFIs. Citi is the lender and structures the product, which invests in one of Russell’s ETFs, the Russell High Dividend Australian Shares ETF.
One reason this approach has become popular is that self-funding warrants can be used by self-managed super funds – something that doesn’t apply to all geared products. They also don’t involve margin calls, which clearly appeals to investors who did get hit by margin calls on their loans during the financial crisis. The warrants also give access to the dividend, and pass through all franking credits.
Nothing is free, of course; the Citi product, for example, has an interest rate of 8.8% per annum, albeit deductible from your tax bill. You need to sit down, work out what you think the market is going to do, and be confident that you will come out ahead after paying the interest.
Leave a Reply
Most Popular Content
- In Flight: the 30-hour novel
- The battle for the Libyan Investment Authority
- Discovery Channel Magazine: the 30-hour novel
- Discovery Channel Magazine: the Great Fire of London
- Discovery Channel Magazine: Fixing Food
- Editorial: Tax relief
The Jakarta Post | Editorial | Mon, December 31 2012, 1...
- The World Bank estimates that forcible “development-induced displacement and res...
- Your article on Microfinance in Eastern Europe is spot on. In fact the key point...
- I'm intrigued but also a little confused by what is going on in the ...
- Hi Chris - loved your smartinvestor article which actually defines investsors' s...
- Could I have this whole poem written by Thomas Ebzery - I am moved by it because...
- I know it is personal but is it possible to obtain a copy of the poem Thomas Ebz...
- I felt very, very sad after reading this beautiful articles. My late dad was sn...
Featured Work, Libya, Sovereign Wealth Funds - Apr 1, 2013 23:23 - 0 Comments
More In Featured Work
- The science of cheating
- Qatar: What has it done with stability?
- Giant steps are what you take
- Euromoney: the shadowy world of Gulf sovereign wealth funds
- Playing with fire: a history of the guitar
Africa general, Big Interviews, Science and engineering - Dec 1, 2012 6:12 - 0 Comments
More In Big Interviews
- Emerging Markets: Zeti interview
- Ed Mitchell: the most famous believer
- Yeager in his own (harsh) words
- Reach for the sky
- So you want to be an astronaut?
Big Interviews, Economics, Featured Work, Foreign Exchange, From the Vault, Malaysia, Politics - Oct 1, 2007 9:52 - 0 Comments
More In From the Vault
- Green finance: cleaning up in China – Euromoney, September 2007
- China’s rainmakers – Euromoney, April 2007
- Shaukat Aziz, Pakistan prime minister: Institutional Investor, December 2006
- The Shariah scholar cartel: Asiamoney, September 2006
- Ethical funds melt down over uranium – AFR, March 2005