The potential and perils of increasing franking credits

In Australia, investors who borrow to buy property benefit from a tax regime that allows them to reduce their taxable income by losses they incur from interest payments and other investment costs for the property they have borrowed to invest in. This tax benefit has been in the news recently, as it always seems to be following a change to tax laws or whenever there is an election.

Like these property investors, Australian equity investors can also borrow to invest. This gearing combines the investors’ funds with borrowed funds making the amount available for investing larger, so thereby magnifying returns (in both directions). Gearing is not suitable for everyone, and we recommend you speak with your financial adviser. Below we provide two potential benefits of gearing as well as introducing a simple and convenient way to gear Australian equities.

But first let’s understand gearing and its impact on an Australian equity portfolio.

The modelled table below illustrates how gearing can affect investment gains and losses in comparison to a fund that is not geared.

Table 1: Modelled performance of a geared and ungeared fund

The table above considers gains and losses in the value of the underlying assets. It does not consider income or associated franking credits. The table assumes that the loan is not increased or decreased as the asset values change.

If you also consider income, you can see another potential benefit of gearing Australian equities. Because you have increased the amount invested, you also increase the amount of dividends you receive, thereby increasing your franking credits.

Table 2: Modelled dividends of a geared and ungeared fund

Now, if we consider the costs of borrowing, which the simple examples above do not, when gearing the dividends are used for interest payments associated with the costs of borrowing. It is important to note that for tax purposes these costs are deducted from the dividends received and do not impact the associated franking credits. The franking credits associated with the dividends received remain. In the example above, irrespective of the borrowing costs, the franking credit would still be $60. In the example above, if the borrowing costs were $150. The taxable dividend would be reduced to $50, but the franking credit would still be $60, making the grossed-up dividend $110.

These are simple examples. Gearing is complex, but you can see the potential benefits it can provide, albeit with additional costs and an increased risk of losing money.

We think there are two ways investors can use gearing and fund managers, like VanEck, are helping all types of investors including SMSFs increase their exposure to Australian equities. Gearing is a high-risk investment strategy and we recommend you speak with a financial adviser to determine if gearing is right for you.

Potential benefit 1 – Wealth accumulation strategy

You can see above in Table 1 that gearing provides greater exposure to the share market and thus potential increased gains or losses compared to an ungeared portfolio. Additionally, geared Australian equity investors receive more associated franking credits than if they were not geared. There is no doubt gearing is riskier and has additional costs, so it is not for everyone, but with careful planning, it can be used as a part of an overall portfolio solution. 

Potential benefit 2 - As a portfolio diversification tool 

By gearing your Australian equities exposure, capital may be freed up to invest in other asset classes.

Think about an investor with $10,000. Putting all your eggs in one ‘asset’ basket may not be prudent risk management. Gearing allows investors to put a portion of their funds in one asset class, enhancing that exposure to the asset class, meaning they can use the leftover funds to invest in other asset classes.

In the table below, and investor A retains their $10,000 allocation to Australian equities, but because they have geared, they have spare capital to allocate elsewhere.

For Illustration only. Assumes gearing ratio of 50%. This is not a recommendation for any particular asset class, or product, or approach. Please speak to a financial adviser to discuss whether gearing is right for you.

A simple way to access a geared portfolio

Gearing can be difficult, but some fund managers do the work for you, creating ‘geared’ versions of their Australian equity funds. These funds combine investors' funds and borrowed funds to invest in an underlying Australian equities strategy.

This week VanEck will launch the VanEck Geared Australian Equal Weight Fund (Hedge Fund) (ASX: GMVW) on ASX.

GMVW invests in MVW, one of the best-performing Australian equity funds since it launched almost 10 years ago.

MVW is different from other Australian equity ETFs because at each rebalance it equally weights its constituents, rather than including companies in the portfolio based on size, measured by market capitalisation. Equally weighted portfolios have historically outperformed their market capitalisation counterparts over the long term.

This is also important in terms of diversification, simply gearing the S&P/ASX 200 for example, amplifies your already significant exposure to BHP and the big ‘4’ banks.

GMVW will also be the most cost-effective geared equity strategy in Australia.

GMVW itself enters a borrowing arrangement meaning investors are not exposed to the risk of margin calls. For SMSF investors, the advantage of using a fund such as GMVW is that they can gear without the onerous paperwork required for direct borrowing and the significant costs that go with that.

Gearing Australian equities may not be suitable for all investors. While it can have benefits, including the tax benefits associated with franking credits, undertaking a gearing and the potential associated benefits will also depend upon your attitude to risks and your personal situation. As always, we would recommend that you speak to you financial advisor or broker.

Key risks: Gearing means that GMVW borrows money to increase the amount it can invest. While this can result in larger gains in a rising market, it can also magnify losses in a falling market. The greater the level of gearing in GMVW, the greater the potential loss of capital. GMVW is considered to have a higher investment risk than a comparable fund that is ungeared. Investors should actively monitor their investment as frequently as daily to ensure it continues to meet their investment objectives. The key risks are outlined in the PDS.