• Kurt Walkom

Can internally geared ETFs accelerate time-to-FI?

Updated: Jun 17

Short answer: Yes. If you’re willing to accept the extra volatility and know which type you’re looking for.

Leverage - powerful and dangerous - depends how you view it! Leverage - powerful and dangerous - depends how you view it!

There aren’t many reviews of using internally geared ETFs to invest for the long-term and those that do exist tend to be very critical (typical example), so for a long time I wrote them off as an investment option.

But, I talked to one of BetaShares’ founders the other day and found out that they and their family invest for the long-term in BetaShares’ geared ETFs.

I decided I needed to dig deeper.

(And no, Pearler does not have a commercial relationship with BetaShares, this is purely research I did to guide my own investing strategy. That said, we would love to partner with most major ETF providers - the more investors who know about ETFs and FI the better for everyone involved.)

What are they again?

Internally geared ETFs use investor funds as well as ‘borrow’ to invest into an underlying index. ‘Borrowing’ means using a derivative contract like a swap, or literally borrowing money from a bank. Gearing multiples typically range from -3x to 3x, with negative multiples representing short positions and positive multiples representing long. I am not a trader so I don’t care about shorting and negative multiples.

Their main benefits seem to be 1) no margin calls because the fund provider manages the leverage; 2) borrowing at institutional rates which are much cheaper than retail; and 3) you don't need to set up a margin loan account or any other account for that matter, you can just use an ordinary brokerage account. The main drawbacks are: 1) you can’t access tax deductions for interest costs and; 2) you have no ability to control of the deleveraging and releveraging decisions as they are made according to strict rules by the ETF provider (this could also be a benefit...).

On the surface, internally geared ETFs seem like they are a margin loan that the ETF provider manages for you. For every dollar you invest, the ETF provider borrows money at corporate rates and invests it alongside your money. When the gearing ratio goes higher than the limit set, the provider sells assets to rebalance the fund (which is essentially a margin call). When the gearing ratio goes lower than the limit set by the provider, the provider releverages by borrowing more money and re-investing it into the portfolio. But in actual fact, only the minority of internally geared ETFs work like this. Instead, most are rebalanced daily, which means they aren't suitable for long term investors like me, and is why they have their bad name and a host of bad reviews in long term investor circles.

The Two Types of Internally Geared ETFs (IGEs)

Alright, so I usually avoid using acronyms but I've written (and you've read) 'internally geared ETF' so many times now an acronym is needed to keep our sanity, so let's call them IGEs from now on.

There are two typical sources of leverage for IGEs: derivatives or borrowings. When derivatives like swaps and CFDs are used to lever, the leverage ratio is rebalanced daily. This is the most common form of IGE and the type that most reviews are written on. From what I have read there are no official names for the different types of IGEs but they are different products for very different investors so different names make sense! Let’s call this type a ‘Derivative IGE’.

On the other hand, when money is borrowed from a bank, leverage is reset much less frequently — only when the predetermined minimum and maximum gearing ratios are exceeded (the gearing range). I’ve given this type the unofficial name of ‘Bank IGE’.

The leverage resetting process and the slippage created by it turns out to be the most critical factor for the performance of all IGEs over the long-term. I’ll get to why in a bit, but for the meantime, here’s how the leverage reset process works: If I have $100,000 and borrow $150,000 to invest, the market value of my portfolio is $250,000 and the gearing ratio is 60% (150k/250k). If the market decreases by 20% my portfolio value becomes $200,000, and the gearing ratio has grown from 60% to 75% (150k/200k). If the maximum gearing ratio is 70%, the ETF would then be deleveraged (‘reset’) by selling enough assets to bring it back inside the specified gearing range.

Alright, now onto the most important factor — slippage — and why the two IGE types are innately more suitable for different types of investors.

Slippage is key

Return deviation from the benchmark index is called slippage. I look at slippage as the overarching measure of how well all my ETF managers do their job because it incorporates management fees as well as how well they track the underlying index. When investing in an index, slippage is the primary factor I use to make decisions on which ETFs I buy across the board.

For IGEs, the manager’s job is tougher than for a traditional low-cost ETF. In addition to fees, borrowing costs and leverage resetting create a substantial drag on returns for both Derivative IGEs and Bank IGEs.

Slippage happens whenever there are rebalances due to market volatility. Moves under volatility create a natural tendency to buy high, sell low, whenever the gearing range is breached. Each iteration of this cycle generates slippage and it is really hard to quantify how much slippage will occur over time because the breaches are dependent on how the market moves over time (known as path dependency).

After doing some digging, I was surprised to find that this path dependency effect can have a massive impact on slippage over the long-term.

Path Dependent Slippage

The more frequently leverage is reset, the more the returns of internally geared ETFs deviate from the index. The worst cases are when the index being tracked is range-bound with daily rebalancing or when there is sufficient volatility to frequently surpass the gearing range as rebalancing must take place to increase or decrease exposure and maintain the fund’s objective.

When the market has sustained upward runs, the fund will repeatedly leverage — buying at higher prices. Vice versa for sustained falls — the fund will keep selling to decrease leverage as the market drops. Both of these are OK in a trend, as you keep buying at higher and higher levels or selling at lower and lower levels as the market uptrends/downtrends respectively. It is the reversals that create drag because when a fund reduces its index exposure, it keeps the fund solvent, but by locking in losses, it also leads to a smaller asset base. Therefore, larger returns will be required in order to get back to even on the trade.

The higher the frequency of rebalancing, or lower the gearing range, the more likely the fund will re-balance on a V-shaped path. On a day-by-day basis, the market is very volatile. This means IGEs with daily rebalancing are definitely not appropriate for long-term investors like me to buy and hold, instead they tend to be used by traders who want to bet on market volatility remaining low. Every Derivative IGE I have seen has daily rebalancing, so I have ruled them out as an option.

That leaves Bank IGEs who tend to use gearing ranges instead of rebalancing frequencies. The question I decided I wanted to answer was:

What level of market volatility results in the return from the Bank IGE being equal to the average market return after accounting for fees and distributions, and how does this compare to the long-term average market volatility?

Turns out it’s pretty damn hard to answer this question. It clearly depends on the individual IGE. I took a look at the historical data for the two Bank IGEs I know of that are available in the Aussie market — GEAR and GGUS. GEAR was launched in April 2014 and tracks the ASX 200. GGUS was launched in August 2015 and tracks the S&P 500. They both have a gearing range of 50 to 65%. I couldn’t get an exact answer to my question from the historical data, but I realised that the classic risk/return chart serves as a good proxy. The charts are below. It’s important to note that all returns are Total Return, meaning that all distributions and fees are accounted for.

GEAR Historical Analysis April 2014 to Present

ASX200 vs GEAR cumulative returns since inception ASX200 vs GEAR cumulative returns since inception
ASX200 vs GEAR: Risk/Return Trade-off ASX200 vs GEAR: Risk/Return Trade-off
S&P500 vs GGUS cumulative returns since inception S&P500 vs GGUS cumulative returns since inception
S&P500 vs GGUS: Risk/Return Trade-off S&P500 vs GGUS: Risk/Return Trade-off

The chart to the left shows the cumulative returns over the past 5 years. It’s more for interest’s sake than anything. It highlights how this Bank IGE performs in upswings, downswings and how it handles volatility (poorly).

The next chart is the golden goose. It compares additional expected return with additional risk of the IGE vs the market. This concept is called the risk/return trade-off.

In this case, GEAR returned 9.6% vs the market’s 7.8%, a 23% increase. The price I would pay though is a 130% increase in standard deviation (25.5% vs 11.1%).

Seems expensive…

GGUS Historical Analysis August 2015 to Present

The S&P500 has outperformed the ASX200 over the last 5 years. As a result, the US-focused IGE fared much better than its Australian equivalent.

GGUS returned 18.82% vs the market’s 12.26%. The standard deviation difference is 28.15% vs the market’s 11.12%. The extra risk is more stomachable in this case considering the 50% increase in annual returns.

What’s missing?

While historical performance takes into account distributions and fees it does not account for the benefits of franking. GGUS is obviously not affected by this but GEAR is. At last check, its franking level was 107.6%.

Weighing it all up

Taking into account the benefits of franking, the effective return of GEAR is ~11.9% per annum (its gross distribution yield is 2.3% more) and the ASX200’s is ~8.8% per annum (conservatively its gross distribution is 1% more). That means that after accounting for franking the effective return increase is ~35%.

Changing my Aussie allocation to GEAR would also mean that my portfolio generates more dividend income than investing in the index (the 12-Month gross yield of GEAR is 7.4%), and I would still be investing in an index-tracking ETF. I like this as I personally prefer the ETF structure to the LIC.

Still, the cost is essentially 2x to 2.5x more volatility. It’s pretty expensive. Same goes for the US-focused IGE, GGUS.

Thinking about the risks: I’m happy to put this money away for 10 years, the timeline is not an issue; the ETF provider may increase their fees, but considering Betashares has no Bank IGE competition in Australia and the general downward trend of ETF fees, I think this is highly unlikely as well; finally, general market volatility may increase over the very-long-term — this one I’m not so sure about.

After doing some more research (chart below) monthly market returns have had a standard deviation of 4.4% this decade, they were 4.1% in the 2000s and they were 3.0% in the 1990s. The recent trend is definitely towards rising market volatility, but historically we’ve had higher.

Standard Deviation of Monthly Market Returns

But honestly, after looking at these data points I realise how difficult it is to predict these things. For example, will investors become more long-term orientated as a whole? That sounds like it would drive down volatility, but if it meant that ETF participation increased then volatility would increase… I just don’t know… Then how about trying to predict the change in frequency of natural disasters, wars or national election surprises? I’m out of my depth — I’m dumping predicting volatility in my too hard basket for now.

My outcome

Bank IGEs, like GEAR and GGUS, are appealing — they seem to offer a way I can accelerate my FI progress without any change to the other elements of my investing process. As a non-homeowner, I am happy to have found a way to leverage cost-effectively (from the shallow investigation I've done to-date debt recycling seems to be a better option for homeowners looking to use leverage). Indeed, I may decide to not own a home at all, as outlined in my analysis of EYs Safe as Houses report a couple of weeks ago (interestingly, these IGEs have about the same level of leverage as modeled in that report). I’ve also recently become aware of other leveraged options like NAB’s Equity Builder and so will have a good look at them before making my final call.

As it stands, if I was confident these Bank IGEs would keep their historical risk/return profile I would commit strongly. Instead, I think I will dip my toe in and see how they go alongside my unleveraged portfolio. It’s a shame an all-world or all-world ex-US Bank IGE doesn’t exist in Australia yet as the diversification benefits of investing outside the US and Australia are very valuable to me. That said, there will probably be one soon.

I remain nervous about what will happen if there is a long-term increase in market volatility, but, assuming I don’t find a better leveraged investing option, I am willing to try them and review. Overall, I'm excited to find an accessible option that allows me to invest with leverage and potentially accelerate my journey to FI.

Thanks for reading! Hope you found this useful. I’d love to know how you use leverage to invest or if you think I should have factored other elements into this analysis.

Comment below 👇👇👇 or if you don't want to create an account shoot me an email on kurt@pearler.com (yes, I know it's a pain-in-the-arse to leave a comment this way, I made an oversight when choosing our CMS platform 😅 - moving to a new one soon!)

Happy FI-ing,

Kurt.

At Pearler, we pride ourselves on the quality of the financial advice we give. Please note though, that this advice has not been tailored for you. You have unique financial goals, circumstances and needs which may make this advice inappropriate, and it is important that you know whether it applies to you. If you are unsure we urge you to speak to someone you trust who is competent with money and understands your individual needs, whether they be a trusted friend or professional.

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