Is it safe to borrow to invest in shares? If so, how should you do it?

Borrowing to invest in property is a popular investment strategy in Australia. It’s often seen as less risky than borrowing to invest in shares. But we should not be so quick to discount the strategy of borrowing in the share market. If implemented correctly, it can be very effective.  

The power of gearing isn’t exclusive to property  

Investing in property has proven to be a successful strategy for many investors. Yet, its success isn’t solely tied to property returns. My analysis reveals that borrowing, or gearing, plays a significant role, driving over 45% of total returns. In simpler terms, without borrowing, property investment returns would be 45% lower. Hence, it’s crucial not to solely focus on property itself but also recognise the power of gearing when investing.  

When investors opt for property investment, they commit to significant monthly repayments due to the large amount of borrowings required. This aspect has its pros and cons.  

On the upside, it compels investors to inject more upfront capital. If invested in the right property and held for the long term, it can lead to substantial wealth accumulation. However, it’s also a downside as property investment necessitates a substantial cash flow commitment, presenting an all-or-nothing scenario. 

On the other hand, investing in shares with borrowed funds offers more flexibility. Investors can adjust their investment amount from month to month, providing greater adaptability compared to property investment.  

But shares have higher volatility  

When it comes to borrowing to invest, there are two main distinctions between shares and property. 

Firstly, shares tend to be more volatile compared to property. While this volatility typically has little impact on long-term investment returns, it can significantly affect shorter-term investments, say within 10 or fewer years. Since borrowing amplifies both gains and losses, investing in shares could lead to substantial losses if the market crashes shortly after you invest. While property values can decline, the likelihood of negative returns is lower, with statistics showing that the probability of the median property value rarely dropping by more than10% is very low. Remember, if you have the patience and fortitude to withstand short-term volatility and losses, in the long run, it is likely that your investment strategy will be successful.  

Secondly, it is a lot more cost-effective to use property as security for a loan/mortgage. While it’s possible to borrow against shares, the interest rates are significantly higher, and the loan-to-value ratio (LVR) is lower.  

There are three borrowing options available  

Direct gearing using a margin loan 

Margin loans were once widely favoured before the Global Financial Crisis. However, since 2009, many financial institutions have ceased promoting margin loans. Margin loans are like mortgages but instead of being secured by property, the loan is secured by shares. Typically, lenders permit borrowers to borrow up to 60% to 70% of an ETF’s value. Nonetheless, if the ETF’s share price falls, surpassing the maximum loan-to-value ratio (LVR), the lender will require you to reduce the loan, known as a margin call. Therefore, you must borrow conservatively or ensure you have a ready source of cash to meet any potential margin calls. Interest rates on margin loans are high, often exceeding 9.5% per annum. 

Direct gearing using an investment mortgage  

If you’ve built up equity in a property you already own, you can leverage that equity to secure a new investment mortgage and use that to invest in shares. This offers two advantages over a margin loan. Firstly, the interest rates on investment mortgages are typically over 2.5% p.a. lower than margin loans. Secondly, you eliminate the risk of receiving a margin call because the loan is secured by property, not shares. 

Internally geared ETFs  

Certain ETF providers offer internally geared ETFs, which means these ETFs maintain a level of borrowings inside the ETF product at a rate of typically around 50% to 65%. Interest is paid from dividend income. Internally geared ETFs offer several advantages over direct gearing being (1) interest cost is around 1% to 2% p.a. lower than an investment mortgage, (2) you don’t have the hassle of arranging a loan and, (3) your personal borrowing capacity is not impacted.  

Geared share ETFs like GEAR, GGUS, and GMVW are some examples of such offerings. Unfortunately, the investment menu is very limited.  

How to combat volatility  

There are two things you can do to combat the relatively high level of volatility in the share market.   

Firstly, investing money on a regular basis such as monthly helps spread the timing risk. Investing monthly over many years and decades means that sometimes you will invest in the market when its cheap and sometimes it will be expensive, but it all levels out in the long run.  

Secondly, maintain a conservative LVR. Often, I recommend maintaining borrowings at 50% which means matching the amount you invest from cash savings with borrowings e.g., if you invest $5,000 per month from cash then match that with $5,000 from borrowings.   

Positive cash flow  

Borrowing to invest in shares is relatively more affordable than property because of higher yields, imputation credits and there are no related expenses. For example, on average, the ASX200 index has yielded 4.5% p.a. in dividend income. Since 80% of dividends are franked, the grossed-up, pre-tax yield is around 6% p.a.  

Therefore, if you borrowed to invest at an LVR of 50%, and invest 60% of that money in the Australian market and 40% in the international market, I estimate that the portfolio would be slightly cash flow positive by around 0.5% p.a.  

How might it work out?  

The chart below illustrates how an investor starting with $10,000 in mid-2001 and contributing $2,500 per month from savings plus $2,500 per month from borrowings would have been able to accumulate substantial wealth.  

In summary, the investor has invested just under $500,000 over 24 years and tripled that money since the net value is over $1.75 million. In addition, it is likely that the dividend income has been sufficient to meet the borrowing costs over that time.  

How to implement this  

If you’re regularly investing a modest sum or anticipate your portfolio staying under $500,000, internally geared ETFs should suffice. 

However, if you’re investing larger amounts or foresee your portfolio surpassing $500,000, it might be beneficial to enlist the help of a financial advisor. They can help build a diversified portfolio of ETFs and low-cost managed funds, exposing your portfolio to several sub-asset classes and geographic markets, utilising evidence-based, rules-based indexing methodologies. This should minimise volatility and maximise investment returns. 

P.S. Betashares announced this week that it will soon be launching diversified internally geared funds: G200 and GHHF.

This is the reason that most people feel more comfortable to borrow 100% of the cost to invest in property over shares. Because the chance of experiencing a 10% negative return is much lower. However, for those investors with a longer investment horizon, there's a strategic… pic.twitter.com/w9F2YMmXgU

— Stuart Wemyss (@StuartWemyss) April 19, 2024