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Sunday, 4 May 2008

Should I Use Leverage?


At the moment I put about $1000 per month into a diversified global stock mutual fund. In 2009 I hope to be able to increase my savings from $1000 per month to $4600 per month. However, what if I can't get a higher paying job by next year? What if I am not good enough?

There may be a way I can still be a millionaire by 35 and that is through gearing, or borrowing money to invest.

I've heard horror stories about margin loans, so I am a little hesitant. However, I am drawn to the idea because of the potential gains.

By the end of this year I should have a net worth of $40,000 and if I assume that I am not able to increase my savings and still save $1000 per month, I can still become a millionaire by 35 assuming stocks grow at 8 per cent a year and I leverage with gearing level (or LVR) of 60 per cent. I calculated this using BT Financial Group's Margin Lending Calculator.

One way I can avoid the messiness of margin loans and escape the threat of margin calls is to invest in an internally geared mutual fund. The website 2020 Direct Invest has a list of geared mutual funds. Most seem to be offered by Colonial First State, which is a subsidiary of the Commonwealth Bank.

Suppose I am not able to invest $2,300 per fortnight next year, which is my plan. What I can do then to be a millionaire by 35 is to salary sacrifice into super to minimize taxes and get co-contribution from the government and also to put a certain amount into CFS geared funds (investing in both Australian and non-Australian companies). The degree to which I will gear depends entirely on how much I need to gear to become a millionaire by 35. I understand that if I invest $2,300 per fortnight and gear completely, I can have not $1 million by 35 but about $1.6 million. However, gearing this much does make me nervous somewhat, so basically I will aim to get $1 million by 35 and not be too greedy since by doing so I expose myself to more risk.

This concept is expressed in the saying, "If you reach for the stars, you'll fall harder." In the career world it is the reason why most parents try to get their children to become accountants or engineers when they grow up as oppose to movie stars. An accountant or engineer will get paid an average salary of maybe $60,000 a year, which is nothing compared to Tom Cruise's $20 million per movie, but how likely is one person going to be the next Tom Cruise compared to getting a job as an accountant or engineer? As John Bogle said, "The greatest enemy of a good plan is the dream of a perfect one."

I have a lot to do next year. I will switch from Hesta to Sunsuper to exploit lower fees. I will also think about gearing. However, I will take baby steps by maybe putting 5 per cent of my portfolio into a geared fund. When I feel comfortable with the taxes, fees, and so on, I may start to divert more of my savings into the geared fund. Virtually all the geared funds in Australia seem to be actively managed. This approach of having core low-cost investments in index funds and satellite investments in riskier investments is quite common and is known as the core-satellite approach to investment.
The core satellite investment strategy proves that indexing and active funds can comfortably sit side by side in a portfolio. Michael Houlihan, Vanguard's Retail Products and Technical Services Manager said: "Many of the large Australian superannuation funds currently use a 'core-satellite' investment strategy and we are seeing an increasing number of advisers applying this strategy to their client portfolios. The main benefit of this approach is that advisers can efficiently implement their asset allocation targets using low-cost index funds and alter the active fund exposure to achieve a desired risk/return profile."

Source: http://www.vanguard.com.au/.../indexdl_2290.aspx

One of the coolest financial innovations I have seen in America is the leveraged ETF. Proshares offers both leveraged ETFs and inverse ETFs. The former is designed to double the returns or losses of a particular index while the latter is designed to give the opposite. That is, if the index goes down, the ETF price goes up and vice versa. For example, the Ultra S&P500 ETF gives double (200%) the performance of the S&P500 index. I wish these products were available in Australia. I probably wouldn't use the inverse ETFs much but I would used the leveraged ETFs. The two can combine to form an inverse leveraged ETF, such as the UltraShort Dow30, which you can use to make money from a long position if you expect the Dow to go down.

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