Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
Why investment trusts use gearing
Investment trusts have a thrust button they can push to boost returns, it’s called gearing. This involves the manager using debt to increase the level of holdings rather than having to sell some securities they’d rather keep to fund future purchases.
This facility is not available to open-ended funds and can be a selling point for investment trusts. For an explanation of the mathematics involved with gearing please read this article.
For income investors this can be particularly useful as it means trust managers can add a greater number of securities to pay out potential dividends.
If a trust is highly geared it does add volatility to the fund though, as markets can also go down. In a bull market, gearing can amplify returns but when sentiment changes it can magnify your losses.
David Holder, senior fund analyst at Morningstar says: ‘If you have a plain vanilla bluechip portfolio with an equity income tilt that has good dividends coming in, it can use some gearing as underlying assets are lower volatility. There’s insurance of returns through the dividends.’
However, Holder also says that a trust with small cap holdings and high gearing is likely to see greater volatility, probably not paying out dividends. Ultimately putting gearing on lower quality assets can cause problems.
Cost of debt
One of the issues with using gearing is when and how a manager locks in the borrowing. During the 1990s some investment trusts locked in borrowing costs when interest rates were in double digits. Given that interest rates have now been historically low for
a long time, in hindsight this was a mistake.
‘Some trusts were paying high levels of interests at 11% which has been a problem for trusts leading some to invest into riskier assets, to find the return,’ says Holder.
Some trusts would simply refinance their debt and bring the level of interest down to a more sustainable level. Holder adds that he likes to see a variety of gearing using shorter term banking facilities which are flexible and cheap.
Although these bank facilities have to be paid for whether you use them or not, Holder says there are lots of trusts locking in cheap long term money at 3%.
The Association of Investment Companies’ (AIC) director of communications Anabelle Brodie-Smith says that some trusts don’t intend to use all their gearing facilities. ‘We had financial advisers concerned that the level of gearing would change once they’d invested for their clients and it wouldn’t be suitable anymore.’
The AIC put out a paper in November 2016 saying the use of gearing in investment trusts put 40% of investment advisers off using the instrument. In the same report 23% of advisers said they were dissuaded from using geared trusts due to compliance reasons and 22% due to the difficulty of getting hold of risk ratings.
According to the AIC, one of the highest geared funds it tracks is the British & American Investment Trust (BAF). This fund is using gearing of 140% so it is at the top end of the scale.
The trust is a UK equity income fund with its portfolio concentrated in investment trusts and biotechnology. Its top holdings include biotechnology firms Geron and BioTime, as well wealth manager St James’s Place (STJ).
It is currently trading at a premium of 116.2% as the trust’s net asset value is 41.63p but its share price is 90p.
Brodie-Smith says, ‘with investment companies they tend to over perform over longer periods because of gearing and the closed ended structure which means managers don’t have to deal with inflows and outflows of money.
‘Once they are listed on the stock exchange, sentiment comes into the share price so it’s not just about asset values. It might add volatility but over the long term all these things tend to work in their favour to give them outperformance’.
A less extreme example is the Value & Income Trust (VIN) which invests in property, typically a geared asset type. According to company’s investor’s prospectus, the trust will use leverage when it believes that the asset funded by borrowing will generate a return greater than the cost of borrowing. There’s no point in borrowing at a rate of 5% and returning less than that per annum.
The company will not raise new borrowings if the total would then represent more than 50% of the total assets. It will use gearing between 25% and 40% and is currently set at 28%.
While the average level of gearing across all trusts is around 6%, when a manager is feeling bullish and has the mandate to push the thrust button, it can really boost returns. The British and American Trust is up 18.9% in six months for example.