Losing it all: The understated risks of gearing

Summary: Gearing into shares is a stratgy that seeks to magnify returns, but it also increases portfolio volatility.

Key take-out: Longer-term research shows that a geared portfolio may not deliver a positive return, even over 10 years.

A current case before the Brisbane courts is a reminder that the ‘Storm Financial’ model that failed in the early years of the Global Financial Crisis is still used from time to time.

In this instance, a client of a financial services firm is suing for inappropriate advice alleging that she and her husband had been advised to borrow against their property to buy shares, and then use a margin loan to increase their exposure even further.

About 10 years ago now, I did an interview with an investor who had lost her entire wealth by investing money in shares, including some borrowed money from her mortgage and a margin loan.  (Read Storm's doomed model).

The current Brisbane case reminds me of an understated reality of borrowing to invest – in most cases when you borrow to invest you expose yourself to the possibility of losing all your investment capital.  It also reminds me of one of the conflicts of interest at the heart of the financial services industry – in this case the conflict of interest between the way gearing as a strategy creates higher fees/brokerage for an adviser, and what might be in the best interest of a client.

A review of the strategy

At the most simple level, gearing is a strategy that seeks to increase the total return of a portfolio, while increasing the underlying volatility of a portfolio. 

The 10-year and 20-year returns from a strategy of 50 per cent gearing into Australian, using data from the Russell Investments/ASX Long Term Investing Report gives some more insight into how the strategy might work over long periods of time. For the 10 years to the end of December, 2017, the average annual return from investing in Australian shares for a person in the highest marginal tax rate was a disappointing 2.7 per cent per annum. However, if that person had used a geared portfolio with 50 per cent leverage, the return falls to a wealth destroying -0.9 per cent per annum.

Over 20 years the returns from a gearing strategy look more attractive for a person using 50 per cent leverage and facing the top marginal tax rate, with returns of 9.7 per cent per annum from a geared strategy compared to 6.7 per cent from an ungeared strategy.

It is interesting that even over a relatively long period like 10 years, that gearing was not a certain way to increase the returns of a portfolio.

The chance of losing it all

What is hidden in these figures is the impact of gearing on volatility. Over the period from late 2017 the Australian sharemarket fell by 50 per cent. For a person with a $200,000 portfolio, this would have seen the average portfolio fall in value from $200,000 to $100,000. However, consider the person who uses the $200,000 to secure a $200,000 margin loan – a total portfolio of $400,000. When their portfolio falls from $400,000 to $200,000 they are left with $200,000 of shares and a $200,000 margin loan – a net position of $0.  In reality they would have been forced to sell shares as their portfolio fell to reduce their margin loan, either way the result would have been close to $0, a loss of everything.

It should be emphasised that the Global Financial Crisis was hardly a period of ‘normal’ sharemarket returns, 50 per cent falls are not common. However, they have happened before in Australia. In 1987. In the early 1970s. During the Great Depression. During these times an investor who was 50 per cent geared in shares would have lost the entire value of their portfolio – a risk that I don’t think is communicated clearly enough to investors who borrow to invest.

The numbers in practice

The following table sets out the annual calendar year returns from investing in Australian Shares since 1970 (first column).  The second column then sets out the effective return on a portfolio that is 50 per cent geared (ie a $100,000 portfolio would then borrow a further $100,000, with the returns expressed as a percentage of the starting portfolio value).  The borrowing rate is assumed to be 400 basis points above the cash rate of return (ie in the current environment the cash rate is 1.5 per cent therefore the borrowing rate used is 5.5 per cent, at the lower end of the current interest cost for a margin loan.  It is interesting to see the extent to which the volatility (highs and lows) of the portfolio is increased through the use of a gearing strategy.  Despite the extra volatility the simple average annual return from the geared strategy is slightly lower over the period since 1970: 11.6 per cent to 11.8 per cent.  If we start in 1975, after the downturn of the early 1970’s, the gearing strategy to the end of 2018 does provide extra returns in the order of 2.3 per cent per annum.

Conclusion

Gearing is a strategy that provides a great example of the Buffett quote, ‘You only find out who is swimming naked when the tide goes out’. 

During periods of good market returns it is a great strategy. However, investing in shares already exposes to a level of volatility that most people find uncomfortable, and intentionally making a portfolio more volatile is problematic.

As well as volatility, history suggests that borrowing to invest does expose people to the entire loss of their capital in extreme situations. However, the ability of a gearing strategy to increase the fees for the financial services industry creates a challenging conflict of interest – as the clients of Storm Financial found out at the start of the GFC.