Unlike most investments, superannuation’s legal structure forces Australians to adopt a very long investment time horizon. Whether you like it or not, you generally cannot access super until age 60.
Investors should use that structural advantage where appropriate, including considering whether gearing has a role to play within their superannuation strategy.
The maths behind gearing can be compelling, particularly over multi-decade periods, because it can magnify long-term returns. However, the practical implementation is far from straightforward.
This strategy will not suit everyone. It depends heavily on a person’s circumstances, risk tolerance, investment timeframe and overall financial position. However, in my view, it has merit and is worth considering, particularly for investors who are still many years away from retirement.
The long-term maths is genuinely attractive
Of course, anyone who has read my blogs for any length of time knows that I like to start with the evidence and the numbers. This situation is no different.
I modelled a scenario involving a 30-year-old with $200,000 in super, contributing $20,000 per year. As they would not be able to access their super for another 30 years, this gives the strategy a very long runway.
I assumed they invested 100% of their balance in an internally geared (35% of gearing) all-growth diversified ETF via a self-managed super fund. I then compared this with investing in a in a comparable ungeared ETF via a low-cost industry super fund investment option (AustralianSuper Investors Direct).
Essentially, I was isolating two key variables:
- Whether the diversified ETF was geared or ungeared; and
- The difference in fees between using a self-managed super fund and a low-cost industry super fund.
For the geared option, I assumed total annual SMSF administration costs of $2,500. The question I wanted to answer was simple: do the higher expected returns from using gearing offset the additional cost of running a self-managed super fund?
The results were compelling.
Using a self-managed super fund and an internally geared diversified ETF, the investor’s balance was projected to grow to approximately $4.3 million by age 60. By comparison, using a low-cost industry fund and an ungeared ETF, resulted in a projected balance of approximately $3.4 million.
That is a difference of more than 26%, which is clearly meaningful.
The key variable in this analysis is the interest rate. I assumed a borrowing cost of 5%, which I think is reasonable, given these ETF funds can typically borrow at around 0.8% above the RBA cash rate. However, if the average interest rate exceeded 6%, the benefit of gearing became less compelling, reducing the balance differential to around 10%.
If the average interest rate exceeded 7% over the full period, the impact of gearing became negative.
I also tested a few other scenarios.
For a 40-year-old with a $400,000 super balance contributing $20,000 per year, gearing resulted in an approximately 19% higher balance by retirement.
For someone with a $500,000 balance who was only 10 years away from retirement, also contributing $20,000 per year, gearing resulted in a little over a 9% higher balance.
The conclusion is not surprising. The longer you have until retirement, the higher your starting balance, and the more you contribute each year, the more likely you are to benefit from gearing. These three factors largely determine whether gearing adds value, and if so, by how much.
Moderate gearing is what makes this viable
The modelling above assumed an average gearing level of 35%, which is broadly consistent with many diversified geared ETFs. However, some ETFs use higher levels of gearing – as high as 50% to 65%. All else being equal, and assuming the cost of borrowing does not increase, a higher level of gearing would be expected to produce a materially higher ending balance.
One of the main advantages of internally geared products is that there is no margin call risk for the investor. In other words, you cannot be forced to contribute additional capital if markets fall. Instead, the fund manager manages the fund’s loan-to-value ratio through regular rebalancing.
Importantly, these funds do not rebalance daily. This helps reduce volatility drag, but it also means the gearing level will fluctuate over time. That is why these products typically disclose their gearing levels as a range, rather than a fixed target.
This is important because volatility creates a compounding headwind for geared investments. For example, if an investment rises by 10% and then falls by 10%, it does not end up back where it started; it ends up 1% lower, and gearing magnifies this effect, which is why moderate gearing and sensible rebalancing are so important.
There are other ways to borrow within super, such as NAB Super Lever, which allows investors to borrow to purchase ETFs inside a super fund. However, the borrowing cost is much higher, currently around 9% p.a. By contrast, ETF providers can generally borrow at institutional rates, which are substantially lower – around 5% p.a.
Volatility is the price of higher returns
With many investments, risk is the price you pay for the opportunity to earn higher long-term returns. Volatility is one way to measure that risk, and we know that the higher the level of gearing, the more volatile the returns will be.
For example, if you invest in a diversified ETF that is geared at 30% and the market falls by 50%, your balance will fall by approximately 71%. If the same ETF is geared at 35%, your balance will fall by approximately 77%.
In theory, many investors will acknowledge this risk and say they are comfortable with it. But the real test is not whether you understand the maths. The real test is whether you can tolerate the lived experience.
You must put yourself in that situation. Imagine logging into your super account and seeing that your balance has fallen by 70% to 80%. Would you still be comfortable with the strategy? Would you stay the course, or would you feel compelled to sell at precisely the wrong time?
A useful behavioural test is to ask yourself what you did in March and April 2020 when Covid hit and markets fell sharply. In hindsight, that was an excellent time to invest in shares. But at the time, it felt incredibly risky, because none of us knew how the situation would unfold.
That is the type of risk investors must be genuinely comfortable with before using gearing inside super.
Sequence-of-returns risk is the underappreciated problem
Volatility is quite predictable, in the sense that we know it will occur. We know that every 5 to 8 years, share markets typically fall by more than 20%. We also know that a 10% intra-year correction is very common. Therefore, volatility itself is not the unknown.
What is far less predictable is the sequence of returns.
For example, assume a 30-year-old employs a geared super strategy today and experiences a 40% market fall within the first five years. In that situation, a geared strategy is still likely to work in their favour over the long run, because they have many decades for the portfolio to recover and compound.
However, if that same investor experiences a 40% fall in the final 10 years of their superannuation accumulation phase, the outcome can look very different. In that scenario, gearing may no longer add value. In fact, the investor could end up with a balance that is around 10% lower than if they had not used gearing at all.
Of course, this is only one specific scenario. It is not a probability-weighted outcome, and a 40% market fall is a significant event. But the key insight is that sequencing risk matters.
This is why younger investors are generally in a better position to consider gearing within super (i.e., putting 100% of their balance in one geared ETF). They typically have a much longer investment timeframe, which gives them more capacity to absorb volatility and benefit from the higher expected long-term return. And older investors should de-leverage as they approach retirement.
There is also a timing element to this, although it should be approached with a lot of humility. Geared ETFs tend to become more attractive after a meaningful market correction, such as a 10% or 20% fall, because prospective returns are often higher and some of the downside risk has already been absorbed. That does not mean investors should try to perfectly time the market, which is almost impossible, but it does suggest that adding gearing after large falls is usually more attractive than adding it after a long period of strong returns.
You will need an SMSF
To implement an internally geared ETF strategy inside super, investors will generally need to establish a self-managed super fund (SMSF). Whilst, many industry funds allow members to invest directly in ETFs, none currently offer internally geared ETFs on their investment menus.
That may change in the future. However, even if internally geared ETFs are eventually added, I expect industry funds would place strict limits on how much of a member’s balance could be invested in them, perhaps 20% or less.
The reason is simple. Industry fund trustees and regulators will be concerned that some members will not fully understand how to use geared investments appropriately. Geared products can be very effective when used correctly, but they can also produce poor outcomes if used without a proper appreciation of the risks.
That is why industry funds are likely to continue offering relatively constrained investment menus. Their priority is to reduce the risk of members making poor investment decisions, even if that means limiting access to strategies that may be suitable for more sophisticated investors.
SMSFs cost money but you can start lean
The cost of establishing and running a self-managed super fund has fallen over recent decades.
There are now some low-cost SMSF administration providers that charge around $1,000 per year. However, a traditional full-service accountant will usually start at $2,500 per year – fees are higher for larger or more complex funds.
There are also several low-cost online share broking platforms that allow self-managed super funds to invest in ETFs in a cost-effective manner.
Of course, if your super balance is relatively low, these costs can be expensive when expressed as a percentage of your balance. However, it is also important to recognise that many SMSF costs are relatively fixed. Therefore, as your balance grows, the fee does not necessarily increase at the same rate, which creates economies of scale.
A self-managed super fund can also have up to four members. I would not typically recommend including children in an SMSF, but a couple can use one fund for both spouses. This allows the fixed costs to be spread across a larger combined balance.
That said, operating an SMSF does involve additional responsibility. It can be time-consuming, and the obligation to keep the fund compliant ultimately rests with the trustees, which means you. This responsibility should not be taken lightly.
Before establishing an SMSF, you must understand the compliance obligations, risks and administrative requirements. These are explained clearly on the ATO’s website here.
The product universe is limited but expanding
There are a several internally geared ETF options available to Australian investors, and I think the menu will grow over time. Whilst investors could construct a portfolio using single market options, I think a diversified ETF probably suits most investors.
It is also important to recognise that this does not have to be an all-or-nothing decision. Investors can construct a portfolio using a combination of geared and ungeared ETFs. This provides flexibility to control the overall level of gearing within the portfolio, rather than simply accepting the gearing level of one product.
Diversified fund options
- GGBL: Betashares Wealth Builder Global Shares Geared. Tracks a global index consisting of ~1,300 developed markets companies ex-Australia. Gearing 30–40%.
- GHHF: Betashares Wealth Builder Diversified All Growth Geared. Invested across a blend of ETFs giving exposure to Australian, global developed and emerging-markets equities. Gearing managed 30–40%.
Single market options
- G200: Betashares Wealth Builder Australia 200 Geared. Invested in the ASX200 geared at 30% to 40% LVR.
- GEAR: Betashares Geared Australian Equities Complex. Same as G200 but higher gearing at 50% to 65%.
- GMVW: VanEck Geared Australian Equal Weight Complex. Geared exposure to the VanEck Australian Equal Weight ETF (MVW), via investor funds plus borrowed funds. Target gearing ratio 45–60%.
- LEVR: First Sentier Geared Australian Share Fund Complex. Unlike the others, this is a high-cost active ETF: actively gearing a selection of high-quality, growing companies across the ASX 100. 50% to 60% gearing ratio. I would not recommend this ETF.
- GNDQ: Betashares Wealth Builder Nasdaq 100 Geared. Invests in Betashares Nasdaq 100 ETF (NDQ), which tracks the largest 100 non-financial companies listed on Nasdaq. Gearing ranges between 30% and 40%.
- GGUS: Betashares Geared US Equities Currency Hedged. Internally geared exposure to the S&P 500, with currency exposure hedged. Gearing ranges between 50% and 65%.
Gearing is not a black or white question
Investing all your super in an internally geared diversified ETF is a strategy that may suit some people at the margin. I say “at the margin” because there are several factors that must be considered, including:
- How long you have until you reach preservation age;
- The cost and complexity of running a self-managed super fund;
- Your behavioural discipline to stick with an evidence-based strategy during periods of extreme volatility;
- Insurance and estate planning considerations; and
- Many other factors specific to your personal circumstances.
The question is more nuanced than simply asking, “Should I invest all my super in an internally geared ETF?”
The key message from this blog is that, mathematically, internally geared ETFs can be quite attractive for superannuation investors with a long investment timeframe. However, they are probably best viewed as a complement to other ungeared ETF strategies, rather than an all-or-nothing solution.
My concern in writing this blog is that it may encourage some people to establish a SMSF without first seeking professional advice. I would strongly caution against doing that unless you have a high level of confidence that you understand the risks involved and have the skill and discipline required to implement the strategy properly.
If you have any doubt, seek professional advice.
