Geared exchange-traded funds (ETF) are becoming a popular investment choice, but advisers should tell clients to avoid borrowing to invest in them given the potential to wipe out other long-term gains.
BT Financial Group technical consultant Ercan Boduk said internally geared ETF products were increasing in popularity and a number had been issued by mainstream players, but their own leveraged positions had the potential to amplify losses that might take years to recover.
Speaking during a webinar today, Boduk noted some of the internally geared funds using Australian Securities Exchange indices had gearing ratios starting at 50 per cent and advisers and their clients needed to be aware of what that meant when investing.
“Taking gearing to the extreme would be to use borrowed funds to invest into an internally geared product and that is something that definitely should not be recommended,” he said.
“In fact, if an internally geared product is being recommended, the source of these funds should always be confirmed with the client in order to avoid a situation of double gearing.
“In extreme circumstances, if a significant market event was to occur, it could take up to 10 years to recover losses due to the magnification effect of gearing.”
He highlighted the effect of gearing in an Australian equities managed fund, pointing out that while it was possible to grow $100,000 by 30 times over 25 years, starting from 1997, the troughs caused by the global financial crisis in 2007 and the COVID-19 correction of 2021 meant that in 13 years over that period there was no effective return.
“As I mentioned, with ETFs gearing at roughly 50 per cent, any sort of market movement is amplified. The positive returns make a pretty looking graph, but it can also look unpretty when there is a big negative market movement where any downside is equally magnified as the upside,” he said.