Advanced Gearing Products

This sixth article in the series on accelerated wealth creation summarises some other products you may have heard help you get rich fast. For example you may have heard of options & warrants, internally geared funds and capital protected funds.

Leveraged products for pussycats and lions

As sure as the sun sets in the west there will always be new wealth creation products launched. Many are suitable for a certain niche, so the trick is to find out which products suit your niche of circumstances.

Today I’m going to cover three that I feel have a broad-ish appeal, namely:

  • Internally geared managed funds
  • Options and warrants
  • Capital protected funds

If you’re a bit of a pussycat who wants a piece of the leverage action then there’s something in this article for you. Kings of the gearing jungle, the lions who want even more leverage will also find some tasty morsels.

Internally Geared Managed Funds

In the last article I mentioned the use of margin loans to use other people’s money to invest using managed funds. Well, there are actually managed funds that borrow money to leverage the money contributed by their investors. So the fund itself is a geared managed fund.

Following are three ways to make use of these products:

  • If you only have a little bit to invest and can’t be bothered getting a margin loan then you can still gear your investments by investing in an internally geared managed fund.
  • Superannuation laws prohibit gearing. However the regulators have said that they are generally satisfied with people investing their superannuation in geared managed funds. So geared managed funds are a way to super-charge your super!
  • Margin lenders will actually allow you to gear into managed funds that are already internally geared. This is a strategy for the lions who like to leverage their leverage.

Options and Warrants

Originally options were created to manage the risk of physically owning something, and they are still used for doing so. For example they gave you the right, but not the obligation, to sell your physical asset at a set date in the future for a set price (perhaps the price you paid for it). So you could buy an option to protect you from losing lots of money if the price of the physical asset went down.

In essence warrants are the same as options. Practically warrants in Australia differ from options based on who issues them, and the terms under which they are issued. (I’m trying not to delve into the complexity of these products.)

Options and Warrants are known as “derivates” since their value derives from the value of a physical asset, such as a share in a company. Whilst they were originally created to manage risk financial folk realised they could make money trading the derivates without owning the physical asset. Because of the way derivates are priced any movement in the price of the physical asset is magnified in the price of the derivative, hence providing you with leverage.

Every week in the newspaper there are courses advertising the wealth creation wonder of derivatives like options and warrants. My personal view is that using them for leverage is a specialist field. If you want to do-it-yourself then you should invest lots of time and money learning. But then I’d say that’s a job as a professional trader, rather than an investment creating passive income.

On the flip side, options are a wonderful tool for managing risk, which leads me to the next product I will write about.

Capital protected funds

Capital protected funds have many different names, probably made up by marketing folk. So let’s focus on understanding the core of how they work. In essence a capital protected fund combines the features of the two previously discussed products: internal gearing and options.

In the marketing spiel for the product you will most often read a pledge that if you invest in the product until maturity (5 to 10 years), then they guarantee you will at least get your initial contribution back. (Albeit, it will have less buying power due to inflation.) If you want to sell before maturity then the guarantee usually is not valid.

How these products facilitate the guarantee is becoming more diverse and complex, making it hard to understand what you’re investing in at times. But one way is the use of options to give them the right to sell the assets at maturity for the same price they initially paid.

One upside of these products is that you get the opportunity to benefit from potentially higher returns from the internal gearing of the investments. The other upside is that you probably won’t lose your money (but you could be worse off in real terms.) The downside is that protection costs money – the guarantee costs you money. So whilst you can get higher returns, you will get less return than if you did not buy protection.

Pussycats may really like these products, once you can get your head around the detail of how they work, since they enable you to potentially get higher returns without that nasty thing that you fear – your money going negative.

Lions may also like these products since many lenders will allow you to borrow the entire amount, yes 100 percent, of your investment in the product. You will need to cover the interest each year. In that sense a lion may liken the cost of protection to the cost of lenders mortgage insurance when investing 100 percent in residential property.

Consider and Learn

As I wrap up this series on strategies and products for accelerating your wealth creation I would like to leave you with two over-arching thoughts.

Consider what is appropriate for you right now. Take into consideration your current circumstances and needs, plus your future goals, and also your level of interest in the nitty gritty detail that some of these strategies require.

Seek out greater knowledge about sexy wealth creation products you hear advertised – maybe with the outcome of eliminating them from your list. Or maybe they’ll be added to your “not right now” list which you use to focus your learning efforts. Continue learning because the knowledge will raise your awareness of the possibilities and also make you comfortable with implementing them.

Right now do something, not nothing; but do what is right for you right now. Plus continue learning to expand the horizon of what is right for you.

Author: Matt Hern

Certified Financial Planner professional, Matt Hern has three times been awarded as one of Australia's Top 50 Financial Planners by The Australian Financial Review Smart Investor. He is passionate about guiding you on the right financial choices to achieve what you really want. Matt Hern is an Authorised Representative of Charter Financial Planning Limited AFSL 234665. All information is general advice only.