03 Jun 2010 | Business

Investment Trusts - Stepping up a Gear 

Gearing can help fund managers improve investment returns for shareholders in a rising market, but there are risks involved says Heather Farmbrough.

One of the things that distinguishes investment trusts from other pooled investments, such as most unit trusts and Open Ended Investment Companies (OEICs), is that they can borrow money over the long term to invest in markets. The aim is to make a higher return on the investments than the cost of the borrowing. This process is known as ‘gearing’.

Generally, providing managers choose the right shares in the right markets, geared trusts should do well when markets rise. The element of gearing makes a positive contribution to overall performance. On the other hand, performance may be dragged down by gearing in a declining market. Returns from the trusts fall while the cost of repaying borrowings remains the same. This magnifies losses to shareholders. The more highly geared the trust the greater the positive or negative contribution from gearing will be.

Trusts do have ways to manage gearing to alleviate some of the risk and to help conserve capital. Borrowings do not always have to be invested in equities. When the outlook for equity markets deteriorates shares can be sold and the borrowings held either as bonds or in cash, or even in other kinds of assets like property. This effectively parks the borrowings until the outlook improves. The cost of the borrowings may be offset to a greater or lesser extent by the income received from the bonds and deposits.

If managers feel particularly negative about the stock market, they can go one step further and sell more equities and hold cash and bonds beyond the scale of borrowings. This is known as degearing, and it can be effective in reducing capital losses during falling equity markets. Managing borrowings successfully is crucial to achieving superior returns in a way not available to open-ended funds. The trick is, of course, to get it right by gearing up into rising markets and gearing down, or degearing, before they fall.

The fact is that most investment trusts gear up very modestly. The Association of Investment Trusts measures gearing in such a way that 100 per cent means no borrowings at all and 115 per cent that borrowings total 15 per cent of shareholders’ funds.

The decision whether to gear or not to gear is taken by the manager and the board of directors. It reflects their view of equity markets and the current availability of shares in companies seen to be attractive at that time. Well-timed, well-managed gearing can make a considerable difference to investment trust shareholders. Superior investment trust returns can often be largely attributed to gearing in rising investment markets. Not even the best managers will get it right all the time but gearing into rising markets can make a difference.

Author: Heather Farmbrough
Heather Farmbrough is a financial writer and editor of Trust.

Investment markets, including currency exchange rates, can go down as well as up and market conditions can change rapidly.

The views that are expressed in this article should not be taken as fact and no reliance should be placed upon these when making investment decisions. They should not be considered as advice or a recommendation to buy, sell or hold a particular investment.