Glenn Freeman: In this edition of "Ask the Expert" I'm speaking with Alex Prineas from Morningstar Manager Research about geared share funds.

Alex, thanks very much for your time today.

Alexander Prineas: Thanks, Glenn.

Freeman: We don't actually recommend any of these funds. We do cover, I think, three funds on which you've got a Neutral rating. But if you can just start off by talking through what are geared funds and how do they work?

Prineas: Geared funds are essentially funds that amplify the upside and downside of your equity investment. So, for every $1,000 that you put into the fund, a typical geared share fund will go out and borrow another $1,000. So, you will have effectively $2,000 of market exposure. So, that's great when the market is going up but obviously bad when the market is going down because you are going to double the negative return that you are receiving in those environments.

And the type of temperament, the kind of risk/return appetite that you need as an investor to really take advantage of that is quite rare. So, we have found that these funds have posted spectacular returns.

Freeman: Any sort of example of what sort of returns roughly? Are we talking 10%, 15% returns or what's the…?

Prineas: Yeah, and potentially more than that at times. I mean, roughly double the equity market return at times. So, we've seen years where equity markets are up 20%. So, you can see these funds delivering returns of 40% in a year which is obviously spectacular. But similarly, we have seen these types of funds lose 50% or more of their market value as well. So, investors need to be going into that with their eyes open and that's why we don't recommend them for most investors.

Freeman: Why would an investor opt for a fund in this sort of circumstance where they could equally take out a margin loan and buy the shares themselves with that borrowed money?

Prineas: That's a good question. I mean, yeah, a margin loan is another way to achieve geared or leveraged exposure. With a fund investment, you obviously get the economies of scale and a professional portfolio manager managing the funds whereas with a margin loan you are doing it all yourself. Also, with a margin loan you are worried about margin calls and you pay a pretty high interest rate because it's all on your own, I guess, personal balance sheet. Whereas with a geared share fund, it's really the job of the portfolio manager to kind of worry about margin calls and manage the portfolio.

Freeman: So, that's what the fee that you would be paying for a fund like that part of that is about recognizing that risk and paying commensurately for it I imagine?

Prineas: Yeah, there's a couple of angles to that. So, because you are investing through a pooled fund where you are pooling in other investors, you are probably going to get a better interest rate than you would do if you took out a margin loan yourself. You are also – there's a complication though in the cost in that typically the geared share managers will charge the asset management fee on the gross amount of assets invested. So, you put your $1,000 in, they will then go and borrow another $1,000 and you will pay a fee on the full $2,000. So, net-net, it probably does work out cheaper than a margin loan for most investors. But we think there's room for the fund managers that offer the geared share funds to maybe offer a lower price than charging the fee on the full gross amount. We think somewhere between the net amount and the gross amount is a more reasonable fee.

Freeman: And you alluded just earlier to the – these funds have the propensity to perform quite poorly, even providing some negative returns in markets that are falling. How do they respond within, say, volatility and some other macro events like rising interest rates?

Prineas: A good environment for a geared share fund is where the equity market is rising at a rate higher than the prevailing rate of interest rats and the rate of interest that the fund is paying to borrow its money. If it's not earning more than the interest rate, then you're probably not going to be better off in a geared share fund. So, yeah, it is an interesting time at moment with potentially – although the RBA isn't raising rates, we are seeing interest rates rising globally and also funding and borrowing is becoming more difficult to obtain. So, that's potentially another headwind for geared share funds.