How geared ETFs work

In simple terms, geared ETFs work a little bit like borrowing money to buy property. For argument’s sake, you might have $100, and you want to buy a (very cheap) house worth $166.67, so you take out a $66.67 mortgage from the bank and make the purchase (at a loan-to-value ratio (LVR) of 40%).

A geared ETF works in a similar way, except it is the fund borrowing the money, not you as the investor. So, you invest $100 in the fund, the fund borrows $66.67, then buys $166.67 of equities. 

Source: Betashares

On a daily basis, such a geared ETF with an LVR of 40% is expected to provide around 1.67 times the exposure to the movements in the underlying share portfolio it holds. 

However, it is important to note that the geared ETF’s exposure to the underlying asset over periods longer than a day will vary due to factors such as the impact of funding costs, management fees and transaction costs; the effects of rebalancing to maintain the target geared exposure range; and the compounding of investment returns over time.

Borrowing to invest can be profitable if the geared returns generated on the underlying investment are higher than the costs of investing, including interest on the borrowed funds. 

If, however, the underlying investment decreases in value, the losses on a geared strategy could also be magnified compared to an ungeared strategy.
 

Potential benefits of geared ETFs

Geared ETFs are internally geared. This means that all gearing obligations are met by the fund, removing the need for an investor to borrow money individually.

In Betashares’ view, this is one of the advantages over other methods of gearing such as margin loans. There is no loan application process, and no possibility of margin calls for investors.

Another benefit is that the issuer is generally able to access funding at institutional interest rates, significantly lower than the interest rates typically available to individual investors seeking to borrow on their own account. 

In recent years, the growing universe of ETFs has allowed investors to combine gearing with diversified broad market exposure. 

For example, an investor may gain moderately geared exposure to 200 of the ASX’s largest stocks - instead of having to invest borrowed funds into a large number of individual stocks in multiple trades.

Gearing into international equities also becomes straightforward to access, as Australian investors can invest in ETFs offering geared exposure to shares listed on global exchanges, via an ETF traded on the ASX.

It’s even possible to invest in a moderately geared portfolio of approximately 4,000 Australian and global equities in a single trade through an ETF.
 

Risks of geared ETFs

As gearing magnifies both gains and losses, geared ETFs might only be appropriate for an individual with a higher risk tolerance and a view that, while markets can go up and down in the short term, they tend to appreciate over a longer investment time horizon.

In a declining market, a geared strategy would be expected to underperform an ungeared strategy. Clearly, the higher the level of gearing, the greater the risk.

Geared investing also comes with greater volatility than an equivalent ungeared strategy. 
 

Case study: Performance characteristics of a moderately geared strategy

To illustrate the performance characteristics of a “moderately geared” investing strategy, Betashares compared the simulated returns of a portfolio representing the largest 200 Australian shares, with leverage maintained at a LVR of 30-40% on a given day, to the returns of an equivalent ungeared portfolio over the period from September 2010 to July 2024. 
 

Moderately geared Australian equities strategy vs. ungeared strategy: Simulated performance illustration using $10,000 investment

Source: Bloomberg, Betashares. Simulated strategy performance is shown net of management fees and costs, being 0.04% p.a. of net asset value (for the ungeared strategy, being the management cost for Betashares Australia 200 ETF, being the fund into which G200 invests) and 0.35% p.a. of gross asset value (for the geared strategy). For the geared strategy, a gearing ratio of 30-40% is applied, with the ratio brought back to midpoint (35%) at end of day if the ratio moves outside this range. Borrowing costs are based on the prime brokerage rates for G200. All returns assume reinvestment of distributions. Does not take into account transaction costs.

This example is provided for illustrative purposes only and is not representative of actual fund performance. Actual outcomes may differ materially. The information is not a recommendation or offer to make any investment or to adopt any particular investment strategy.

Simulated past performance is not indicative of future performance of any fund or strategy.

In this example, an initial $10,000 investment in the ungeared strategy would have grown to around $31,400, while the moderately geared strategy would have been worth around $38,800 at the end of the comparison period. 

The example further shows that in addition to these gains, the franking credit entitlement for the geared investment strategy would have been approximately 1.5 times the ungeared investment strategy (subject to an investor’s eligibility to those franking credits).

The cumulative total return for the geared strategy over the comparison period was around 135% that of the ungeared strategy, less than the daily target geared exposure range. This demonstrates that, over periods longer than a day, returns will not necessarily be within the target geared exposure range for such a strategy.

DISCLAIMER

This article is for educational purposes only, does not constitute financial advice and does not take into account any person’s objectives, financial situation or needs. Independent advice should be obtained from an Australian financial services licensee before making investment decisions.

There are risks associated with an investment in Betashares Funds. Investment value can go up and down. An investment in any Betashares Fund should only be made after considering your particular circumstances, including your tolerance for risk. For more information on the risks and other features of the Betashares Funds, please see the relevant Product Disclosure Statement and Target Market Determination, available at www.betashares.com.au.