The BlackRock UK Absolute Alpha fund (rating under review) has recently announced that it plans to shift its investment mandate to incorporate higher leverage. The move is an attempt to improve the fund's long-term track record, which has lagged its peer group. But to what extent can leverage really be an answer to delivering stronger performance for fund managers?
The BlackRock fund will now be able to take gross exposure to the market of 150%, compared to 100% previously. As the fund is open-ended, the leverage will come through the use of derivative instruments such as contracts for differences (CFDs). The question for investors will be whether new managers Nick Osborne and Nigel Ridge can be sufficiently skilled in their stock-picking and market positioning to ensure that the leverage improves rather than erodes performance.
In judging whether leverage can improve performance, the investment trust market is the obvious place to start. Open-ended funds can still only use derivatives to create leverage, while investment trusts have a range of options open to them. They also have a longer history of using leverage.
Use of Leverage Among Investment Trusts
Leverage tends to be specific to individual trusts. Investment trusts can either have structural gearing, where there is long-term gearing in place providing an effective 'hurdle rate' for the trust's investments, or it can be investment-led with the fund gearing up when the fund manager sees most opportunities in the market. Jackie Beard, director of closed-end fund research at Morningstar says: "Where the debenture is already in place already, the decision is largely made, as in most cases it’s too expensive to repay it early. The manager simply needs to decide whether to offset it. Some trusts are more active in their gearing. In general, we prefer it to be an investment decision, but different managers have had different experiences—some find the board's stance helpful, some find it unhelpful. It will often depend on the relationship between the board and the manager."
Equally, different managers will approach fixed term leverage in different ways. Beard says: "For example, the Edinburgh Investment trust (EDIN) has fixed term debentures. The manager's view is that there are enough opportunities in the equity market to cover the cost of gearing. In contrast, in trusts such as Merchants (MRCH), run by Allianz, they prefer to keep it in higher yielding equities. In British Assets (BSET), they offset the gearing with a similar maturity dated fixed income. "
Leverage Tools Available to Managers
The problem with longer-term fixed gearing is that interest rates are notoriously hard to predict. Therefore, the trust may be locking in gearing at a high rate, which can act as a long-term drag on fund performance. There are a number of trusts with debentures of 10% or higher.
There are a number of options for shorter-term borrowing. This is more flexible and is often more manager-led than board-led. The manager will ask for additional gearing when markets offer the best opportunities. Among the short-term gearing options are non-secured loans, perhaps with revolving facilities, convertible unsecured loan stock (CULS), and contracts for differences. Then there are new and innovative structures such as the royalty used on the BlackRock World Mining trust (BRWM). The trust bought a small stake in London Mining's (LOND) Marampa licence in Sierra Leone. It will acquire a 2% revenue-related royalty from any iron ore sales over the life of the mine, for which it paid $110 million in cash.
Beard says that CFDs are becoming an increasingly common way to structure gearing, as they are cheap and flexible. Equally, she says, a number of trusts are looking to increase their gearing: "Long-term debt is cheap at the moment. During the crisis, none of the banks could lend long-term to investment trusts. Trusts are now looking at longer term debt. They can get decent rates—for a fundamental believer in equity markets, debt is a good thing."
Leverage and Fund Performance
But can it contribute to performance? Beard says that in certain cases, leverage has made a notable difference to performance. She gives the example of Sarah Whitley on the Baillie Gifford Japan trust (BGFD). Whitley took the view that markets would be supported by the changes wrought by 'Abenomics', and maintained her gearing. The trust has been an extremely strong performer as a result, returning double that of the wider AIC Japan category.
However, Whitley is a skilled stock-picker and put the leverage to work prudently. The market crash of 2007/2008 was littered with examples of trusts where gearing went wrong. Property was perhaps the most obvious. As it crashed, its gearing magnified the losses. However, there were also straightforward equity funds where gearing went wrong.
Investors therefore need to analyse the extent of a fund's gearing and judge whether it is being used well. This information is not always easy to find. The AIC gave guidance to investment trust boards in October 2012, asking them to quote a gearing range. Morningstar has started to include those gearing ratios on its statistics. Ultimately, the most important decision for investors will be whether a manager can be trusted to make the most of the gearing they are given.
