Gearing is often cited as an additional—and beneficial—tool that can be used within investment trusts to generate extra returns for shareholders. But with gearing comes extra risk. Investors should ask themselves 'is it a fair risk/return trade-off?' Meanwhile, what can we tell about risk and return when looking at gearing levels in different funds?
Taking a Long-Term Strategic View
One would naturally hope that, with extra risk comes extra return, but for most investment managers to stand a chance of making good on this pledge, we need to allow them time for their strategies to work. When gearing is used in a strategic way—which is the more usual method—we need to look beyond short-term performance numbers; strategic deployment of gearing means they’re taking a longer-term stance rather than trying to time the market and make tactical calls. As an industry, we’ve become too fixated on 12-month performance or less, and yet many of the managers with whom we speak are buying companies on at least an 18-month view, and often longer. This indicates that it’s simply not reasonable for investors to expect them to work miracles through the use of gearing over just a handful of months.
Gearing Levels Can Fluctuate
What we can look at on a shorter-term view, however, is how gearing levels fluctuate as an indication of confidence in markets, particularly in funds in which gearing is deployed in a tactical way. High levels of cash can be indicative of a lack of opportunities in the market—thus expensive valuations—and/or concerns on a bigger scale over the wider economy. Funds with fixed-term debentures will show a bigger differential between their net and gross gearing figures at these times. Conversely, that differential will shrink when confidence is high and that loan will be deployed in the market. For example, the Gold-rated City of London Investment Trust (CTY) has both fixed-term debentures and an overdraft so the latter can be used tactically. Manager Job Curtis reduced the overdraft in late 2011 on concerns over the European debt crisis and its impact on the UK market, thus net gearing at that fund reduced by nearly 4%. But in March 2012 he drew down again on the overdraft to take advantage of depressed valuations.
As of mid-January, approximately half of conventional investment trusts are geared, with the average level of gearing in equity investment trusts less than 15%. These fund’s investment managers and boards aren’t taking excessively big risks with their gearing but, generally, they believe in long-term performance from equity markets and thus are using this tool to help generate extra returns for their shareholders. A good example is found in European equity funds, given the problems in Europe in recent months. Even in these times of stressed markets, managers like Vincent Devlin and Sam Vecht at the Silver-rated BlackRock Greater Europe Trust (BRGE) have been finding opportunities and in August they drew down notably on their gearing facility for the first time in almost a year. It’s that kind of action that we think increases the appeal of the investment trust structure.
Then we must ask the question, is the extra risk worth taking? The answer varies according to where in the world you’re investing and in which asset class—and of course the manager in charge of that fund. Take, for example, the Silver-rated Baillie Gifford Japan Trust (BGFD), run by Sarah Whitley. Over ten years to December 31 2012, that fund has made more than 8% annualised for its shareholders, compared with its Morningstar Japan Large-Cap Equity category average peer’s gain of just 3.2%. Whitley has used gearing through a number of currency loans to good effect during that time and, what’s more, she’s proven that it is indeed possible to make money in Japan, and has comfortably beaten both the Nikkei 225 and the Topix over that timeframe.
The High Risk Scenario
Conversely, in a fund such as the Neutral-rated Invesco Leveraged High Yield Trust (ILH), arguably it didn’t work out so well for investors in the last few years, partly because of the problems in the high yield bond market but also because gearing has compounded that impact. The fund carries a High Morningstar Risk Rating over five years, and has had double-digit gearing deployed throughout that time. So investors have shouldered more risk and not had the benefit of better returns over that period. That said, in 2012 the fund’s fortunes started to turn and the use of gearing has helped boost returns. This emphasises just how important it is to look long term and not get too fixated on short-term fluctuations in performance.
Gearing is a powerful tool for investment managers when used well, and in the right markets. Investors shouldn't be put off by gearing in a fund, however, they must be sure to keep their eyes wide open and maintain a long-term view.
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