Banking Matters – Geared Funds

24Feb2006

The Henley Group has never recommended geared investment products to its clients but we often come across individuals that do have such products. This article looks at why more and more investors with such products are coming to realise that they may have misunderstood the risks associated with gearing their investments.

Many of the individuals that we meet with geared investments believe that they have been following a low risk strategy. However, although the underlying products may well be low risk, gearing your investment is unlikely to be. The Securities and Futures Commission recently warned that it regards gearing as a “high risk investment strategy, even when coupled with an otherwise low risk product.”1

An investor “gears” his investment when he takes out a bank loan and uses the loan to increase the total amount of his investment. The investment product purchased is then used as security for the bank loan. Because the amount of the investment is increased, any returns on the investment are also increased. This is the primary purpose of gearing and in some cases has been used as a selling point for investors. All well and good while the markets are strong and investment returns remain higher than loan interest rates. Not so good, however, if interest charges start to outstrip the investment returns.

The downside to gearing is that any decreases in value are also amplified – as are the losses suffered. The impact of other risk factors is also amplified if the investment has been geared. Take, for example, an investor who has $100,000 to invest. He chooses to gear his investment and takes out a loan for three times that amount, resulting in a total investment of $400,000. The investment fund then falls in value by 25%. If his investment was un-geared, he would lose $25,000. Because he has geared his investment, his actual loss is his entire capital investment of $100,000. He may also end up owing money to the bank if additional interest charges are payable.

This is a very real scenario for some Hong Kong investors who geared their investment in offshore with-profits funds in 2001. Some are now facing the prospect of losing their entire capital and owing money to the bank as a result of poor investment returns, interest rate charges and the impact of Market Value Adjusters (“MVAs”) by life offices. The ongoing imposition of the MVA means some investors cannot withdraw their investment, even when other exit penalties cease to apply, without incurring a deduction of up to 25% of their investment. For those who have geared their investment three times, this equates to the loss of their entire capital. Although a number of offshore life offices have recently announced some reductions in their MVAs, in some cases they have yet to be lifted entirely. As a result, affected investors are left with the unenviable task of weighing up whether they are likely to lose more by staying in the geared investment or by getting out. A very unhappy outcome for investors who invested in geared funds on the basis that they were supposedly low risk.

In some cases, additional risk has been added with individuals borrowing in a different currency to that of the investment. This may initially look good if the interest rate on the loan is low due to the currency selected, but it can be a recipe for disaster if the currency strengthens, as it will take more funds to repay the loan.

Of course, gearing in its own right is not wrong. Indeed, most of us will have benefited from gearing in the form of a mortgage on property when buying a home or perhaps an investment property. The fact remains that gearing significantly increases the risks associated with any investment as well as the potential gains and losses. This needs to be understood and should of course have been explained at the time that such investments were initially made.

In 2003, a Hong Kong Court found that the combination of gearing, currency mismatch and interest rate risks, along with the risk that the bank might prematurely terminate the investment if additional collateral could not be raised, meant that the investment had a high level of risk. This was deemed inconsistent with the conservative investment that the client indicated they had requested.

The Securities and Futures Commission has made it very clear that “firms that promote gearing as low or no risk or put the extra commission arising from gearing before client interest can expect harsh punishment.”2 Indeed, in December 2005, it reprimanded a financial advisory firm for recommending that a couple gear their investment in a with-profits fund four times and failing to provide a balanced explanation of the advantages and disadvantages of gearing an investment. The couple reportedly lost more than their entire investment due to interest charges and exit penalties imposed.

Investors considering gearing their investments should take heed from the experience of those who have gone before them. Consider and seek advice on both the advantages and the disadvantages of gearing your investment and be aware that if you are looking for a conservative investment, geared funds are probably not for you.