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Big jump in gearing in UK-only sector at odds with approach taken by global trusts
Thursday 13 Aug 2020 Author: Steven Frazer

Investors are understandably preoccupied with the ongoing Covid-19 pandemic and what a potential second wave and lockdown return might mean for the economy and individual savings and investments.

On 6 August the Bank of England said the economic shock triggered by the coronavirus crisis will be less than initially feared but the bounce-back will take longer and inflict lasting damage on jobs and growth.

The Bank’s governor, Andrew Bailey, now expects UK GDP to decline 9.5% in 2020, and while this was an improvement on the 14% economic shock anticipated at the end of May, the UK economy may continue to struggle for pre-pandemic growth rates until 2023.

But while investors might have expected to asset managers to put on their tin hats, UK-focused investment trusts have substantially increased borrowings during lockdown in the hope of picking up stocks on discounted valuations.

Fidelity Special Values (FSV), run by the popular Alex Wright, and Mercantile Investment Trust (MRC) are among a number of trusts in the Association of Investment Companies’ (AIC) All UK Companies sector to have pulled gearing levers to take on extra borrowings since the outbreak sparked a plunge in global stocks in February.


Average gearing across the AIC’s All UK Companies sector jumped by more than a third between the end of February and 7 August, rising from 8% to 11%. The sector average at the end of 2019 was 4%.

This is in stark contrast to investment trusts with a global remit, where managers have been reeling back on borrowings since March. This can partly be explained by the UK’s relatively sluggish stock market recovery compared to the S&P 500 in the US, where AIC Global sector investment trusts typically have the majority of their assets.

The FTSE 100 remains 18% down on its pre-pandemic levels, compared to the S&P 500, which has now recovered all of its Covid losses.

Gearing undeniably increases risk for investors because borrowings will exacerbate overall asset and share price performance.

‘Gearing is a unique feature that investment trusts have in their toolkit, and they should use it,’ said analyst William Heathcoat Amory at investment trust researcher Kepler.

But all leverage isn’t equal. Some use fixed rate borrowing, others prefer more flexible arrangements. ‘We call fixed rate borrowing structural gearing,’ said Heathcoat Amory. The advantage is that interest rates stay the same and so repayments can be managed more easily, versus the risk that you end up with expensive debt if interest rates fall, as has happened in recent years.

More flexible, or ‘tactical gearing’ has been favoured by Henderson EuroTrust (HNE), which is very focused on opportunistic stock valuation-driven ideas. Manager Jamie Ross typically runs the portfolio of a ‘one in, one out,’ rule says the Kepler analyst, and gearing can be used to buy new stocks even when he is reluctant to sell a current holding.


Alternatively, Dunedin Income Growth (DIG) uses a hybrid approach, typically tapping longer-term and lower-cost structural gearing, with the additional flexibility to employ flexible gearing on to this.

‘The managers are reluctant to apply tactical gearing unless they deem there to be particularly compelling opportunities to do so,’ said Kepler’s Heathcoat Amory. ‘The recent market sell-off provided just such an opportunity to increase exposure to high-quality names, which they believed to have seen unwarranted reductions in their share price relative to their ongoing prospects and operational performance.’

‘The style in which trusts employ gearing should ideally match the style in which managers invest,’ he said. ‘We believe managers who are more valuation-agnostic might be best suited to structural gearing. On the other hand, managers who invest with strong price discipline, in both buying and selling, might suit a more tactical use of gearing.’

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