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Is Internal Gearing Equivalent to "External" Gearing?

Discussion in 'Investing Strategies' started by Norak Bastiat, 6th Oct, 2007.

  1. Norak Bastiat

    Norak Bastiat Well-Known Member

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    Some mutual funds like Colonial First State Geared Share Fund gear internally. You give money to Colonial First State and they borrow and invest for you. If you gear normally (or externally, as I will call it) then you yourself borrow money from the bank and invest in an ordinary fund or in property, etc.

    Suppose you got a job that pays $x per year. If you went to the bank, took out a loan, and borrowed money to put into a normal Australian shares fund, would you make the same money as if you put $x per year into an internally geared share fund like Colonial First State Geared Share Fund? Are they equivalent?

    If they are, why would anyone bother with the hassle of external gearing? For example, instead to borrowing money from the bank to invest in an investment property, why not put money into a geared unlisted property trust, which would offer more diversification? I don't know of any geared unlisted property trusts in existence though.

    If the fund manager borrows on your behalf, they might charge a fee for that service. On the other hand, they may get quantity discounts.
     
  2. bundy1964

    bundy1964 Well-Known Member

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    There are property ones if you know how and where to look -

    Australian Unity - Investment Services - Geared Property Income Fund - Retail Units

    Macquarie Property Income Fund strategy leads the pack, adds a second manager

    apifund

    Last one with monthly income does look interesting to me.

    You can of course gear an already geared investment if your brave. Fund gearing usually caps at 60% due to there need to make a profit to distribute franking credits from a trust structure and that limits leveraged CG or losses.
     
  3. Rob G.

    Rob G. Well-Known Member

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    Two Issues come to mind:

    1. The entity with the lowest cost of capital should be the borrower

    2. Negative gearing requires other income to offset losses

    Cheers,

    Rob
     
  4. tasmo

    tasmo Well-Known Member

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    Bundy1964, the maths implied in above look suspect :p.

    Geared Fund mangers have target gearing levels more usually of around 2:1 (50%lvr) with 2.5 :1 (60%lvr) upper limits. At 2:1 gearing the total company dividends received are double a non geared investment (or put another way, only half of the investments incur an interest expense, investors fund half the share purchases) These dividends (3-4% doubled by gearing exposure) pay the interest expense incurred by the funds, but would leave little profit to pay out to investors.

    Gearing higher than 60% would mean the funds may not be able to pay interest expenses from income rather than focus on distributions, so is this is more the reason the Funds limit their gearing to 50-60%.

    As profits and distributions of Funds can be substantially higher than company dividends this implies distributions are funded by realized capital gains through the Funds trading shares. I can confirm that distributions I have received through multiple geared Funds (and other Funds), have had major (discounted) capital gains components.

    Also refer to Geared Fund profiles and you will see most have very little franked dividend components, but large capital gains components within their distributions.
     
    Last edited by a moderator: 6th Oct, 2007
  5. tasmo

    tasmo Well-Known Member

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    In respect of item 1 above, interest rates is only one factor of many to take into consideration, so I would not be so bold as to make the above uncompromising recommendation :(.

    Number 2, geared funds aren't specifically negative geared strategies, they can be more neutral or positive geared strategies :p.
     
  6. AsxBroker

    AsxBroker Well-Known Member

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    Hi Norak,

    Most people gear and borrow from an institution to be able to claim a tax deduction, if you invest in a geared managed fund you won't be able to claim a tax deduction as the fund claims deductions etc for itself and gives you a net return. Depending on your taxable income you may like to claim deductions or not.

    Most managed funds have around 50% LVR as they know that they have a responsibility to the unitholders and if they mess up big time no one will ever give them money again...it sort of ruins their business.

    I'm not sure whether the fund manager actually makes a cut on the borrowings in a normal geared fund, they usually just make a cut on having a larger FUM to take their 1% or whatever MER from.

    Cheers,

    Dan

    This is general information. Speak to your FPA registered Financial Planner, Accountant or Tax Adviser before making an investment decision.
     
  7. Rob G.

    Rob G. Well-Known Member

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    "In respect of item 1 above, interest rates is only one factor of many to take into consideration, so I would not be so bold as to make the above uncompromising recommendation :(."

    Cost of capital is not merely the interest rate.

    It factors in the overall opportunity cost of capital, risk premium and of course tax.

    Trusts are rather curious, as income types flow through to the unit holders. Therefore borrowing by the trust may not be so different from borrowing in your own name, e.g. if the interest rate for you both is similar as it is effectively you marginal rate for the deductions.

    The more the trust gears, the better the figures look in a rising market.

    The advantage of personal gearing is that you control the gearing level of gearing, returns and risk.

    Borrowing in your name to buy into an ungeared fund increases you cost base for capital gains tax (fund units higher cost as net assets higher). This means that all those nasty little non-assessable amounts in your distributions do not generate capital gains tax so soon (CGT event E4).

    All this and getting deductions at your desired level of risk.

    Cheers,

    Rob
     
  8. tasmo

    tasmo Well-Known Member

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    I would say most people borrow to invest to increase their total investment and maximize overall return. :p

    However it does depend on your financial circumstances, and in my case for the above reasons given, I employ both personal borrowing and internally geared funds to ramp up my investments as part of my overall investment strategy.