It is generally known gearing offers the potential to grow wealth at a faster rate than no gearing. However, many believe that a high growth rate is required for geared investments to breakeven. This case study shows how a Protected Loan with a 50% LVR can outperform a non-geared portfolio at a growth rate of just 0.7%.
Introducing Hamish and Lisa
Hamish and Lisa are both 45 years of age and have recently consolidated their superannuation assets to start the 'Hamish and Lisa Family Superannuation Fund'. Their aim is to invest in assets which provide potential for capital growth. They believe that equity markets will rise up to 70% over the next five years which is broadly in line with the historical average performance of the ASX 200*. With this view in mind, Hamish and Lisa explore possible strategies that could outperform direct investments.
Hamish and Lisa, after discussing their situation and also carefully considering the fund's risk profile and time horizon, decide to invest in a $500,000 Protected Loan (PL) with a 50% gearing/ protection level. This means that their SMSF will contribute $250,000 equity, with the balance of $250,000 borrowed under the PL. They will also apply a cap of 70% on each of the shares which means they will be entitled to all growth up to this level during the five year loan. In exchange for foregoing growth above this cap, Hamish and Lisa's interest rate is discounted by 2.92% from 11.69% to 8.77% p.a. This interest rate includes the cost of borrowing plus the cost of protection.
The terms of Hamish and Lisa's PL are:
|Loan to valuation ratio (LVR)||50%|
|Cap level per share||170%|
|Portfolio||NAB, WBC, CBA, ANZ, RIO, BHP, ORG, WPL, STO, WES|
|Protection premium||$0 – the protection premium is built into the interest rate|
|Tax rate of SMSF||15%|
|Variable interest rate||8.77%|
|After tax benefit of PL i||$78,951|
i After tax benefit = protection premium + dividends + franking credits + interest deductions
The after tax benefit of the PL means the geared investment will generate a return of $78,951 over the five year term with no capital growth taken into account. This is because the dividends and franking credits offset the protection cost and interest payment. By comparison, the after tax benefit of the ungeared investment of $250,000 is $86,104.
Establishing the point where a geared investment outperforms a non-geared investment will depend on variables such as the interest rate, the expected growth rate and portfolio yield. In this case, the growth rate at which the geared portfolio will outperform the ungeared portfolio is just 0.7% p.a.
|Start of investment|
|Investor's equity contribution||$250,000||$250,000|
|Value of portfolio||$500,000||$250,000|
|Capital growth||0.7% p.a.||0.7% p.a.|
|Value of portfolio ii||$517,747||$258,873|
|Portfolio capital gains tax iii||-$1,775||-$887|
|After tax benefit||$78,951||$86,104|
|Net gain after tax over term iv||$94,923||$94,091|
|Net cashflow v||$344,923||$344,090|
ii Value of portfolio at maturity = value of portfolio at start x (1+capital growth rate) ^ term
iii Portfolio capital gains tax = portfolio gains x 10% CGT rate. Note that this is the current rate and may be subject to future changes
iv Net gain after tax over term = portfolio gains + portfolio capital gains tax + after tax benefit
v Net cashflow = value of portfolio at maturity – loan amount + Portfolio capital gains tax+ after tax benefit
- The point where the geared investment outperforms the non-geared investment is 0.7%.
- The PL's 70% maximum growth over the 5 years equates to a maximum of 11.2% compounded growth p.a. If the market returns 11.2% p.a. the PL will return a maximum of $644,083, which is $325,000 more than a non-geared investment.
- With the geared investment capped at a maximum return of $644,083, the ungeared investment will continue to grow but will only outperform the geared investment at a growth rate of 20% or more.
In this example, we have assumed the investment is held to maturity and generated capital growth over the five year term.
- capital growth potential on a larger share portfolio
- receive all potential dividends, franking credits and tax income
- Invest in the share market with loan protection
- no margin calls
Produced by Commonwealth Bank of Australia ABN 48 123 123 124 (Commonwealth Bank). The Options and Lending Facility is a product of Commonwealth Bank which is administered by its wholly owned but non-guaranteed subsidiary Commonwealth Securities Limited ABN 60 067 254 399 (CommSec), a Participant of the ASX Group.
A Product Disclosure Statement is available and should be considered before making any investment decision about this product. The Options and Lending Facility provides sophisticated financial products which may involve dealing in derivatives. Unless you are familiar with derivative dealings and such products, these products may not be suitable for you. Bank and Government charges apply. Applications for Protected Loans and Interest in Advance Loans are subject to Commonwealth Bank's normal credit approval. A copy of the Product Disclosure Statement can be obtained from CommSec by calling 13 15 20 or emailing firstname.lastname@example.org
This document has been prepared without taking account of the objectives, financial situation or needs of any particular individual. Because of that, before acting on the information in this document, a potential investor should consider its appropriateness to their own circumstances, having regard to their own objectives, financial situation and needs. Neither Commonwealth Bank nor CommSec specifically recommend the stocks used in the above hypothetical scenario. Potential investors should consult their professional tax adviser about the tax implications of any products to their own particular circumstances.
This case study is for illustrative purposes only – neither Commonwealth Bank nor CommSec are specifically recommending the Securities used. The case study is based on the market prices as at the date of preparation of this document and may change as market conditions change. The franking and dividend assumptions are based on public statements by the listed entity and/or an average of market analysts' forecasts. Their accuracy cannot be guaranteed and future outcomes may vary markedly. The case study assumes that franking credits and dividend rebates are fully available to investors. Ref quote 77601