Is the Extra Risk from Gearing Worthwhile?

Gearing is a useful tool, helping investment trust managers pump up returns, but gearing can be risky if it's not used carefully and strategically

Jackie Beard, FCSI 3 October, 2012 | 2:15PM
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Gearing is often cited as an additional--and beneficial--tool that can be used within investment trusts to generate extra returns. Essentially, gearing involves borrowing money to invest in securities over and above the money contributed by shareholders. Gearing increases a fund’s upside potential but also considerably magnifies its downside risk.

Take for example, an investment trust with £100 million in assets that borrows an additional £100 million, then invests the entire sum (£200 million) in the equity market. A 50% return on that £200 million investment would equal £100 million. Once the trust repays its loan, it is left with £200 million (its original £100 million, plus the £100 million it earned on its investments). That’s a 100% return, which seems highly desirable. But on the flip side a 50% loss on that same £200 million would equate to a £100 million loss. The fund’s entire capital base would be wiped out, and investors in this example would be left with nothing. It’s clear from this example that gearing also adds extra risk.

When examining investment trusts, investors need to decide whether gearing represents a fair trade-off and what they can read into gearing levels in different funds.

Gearing in Trusts: Take a Long-Term View

One would naturally hope that with extra risk comes extra return. However, 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 trust managers are 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 performance over 12 months or less, and yet many of the managers with whom we speak are buying into companies on at least an 18-month view, and often longer. It’s simply not reasonable for investors to expect them to work miracles through the use of gearing over just a handful of months.

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, meaning managers are seeing expensive valuations and/or concerns on a bigger scale over the wider economy. At such times, funds with fixed-term debentures will show a bigger differential between their levels of gross gearing, or overall indebtedness, and their levels of net gearing, or a trust’s outstanding debts minus its cash. Conversely, that differential will shrink when confidence is high and the money from that loan is deployed in the market.

Gearing Example: City of London Investment Trust

For example,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 based on concerns over the European debt crisis and its impact on the UK market. Net gearing on that fund reduced by nearly 4 percentage points. But in March 2012 he drew down again on the overdraft to take advantage of depressed valuations.

This is one way to interpret gearing levels. But as for the use of gearing itself, is the extra risk worthwhile? The answer varies according to where in the world you’re investing and in which asset class, as well as the manager in charge of the fund.

Gearing Example: Baillie Gifford Japan

Take, for example, the Silver-rated Baillie Gifford Japan Trust (BGFD), run by Sarah Whitley. Over 10 years to August 31, that fund has made more than 5.5% annualised returns for its shareholders, compared with an average gain of just 1.2% from peers in the Morningstar Japan Large-Cap Equity category. Whitley has used gearing through a number of currency loans to good effect during that time. What’s more, she’s proven that it is indeed possible to make money in Japan, and has beaten both the Nikkei 225 and the Topix over that time frame.

So is gearing worthwhile? In some cases, yes. Should gearing scare you off from investment trusts? Provided you understand how gearing works, then no, don’t be scared off by this potentially useful investment tool.

(With additional notes from Alanna Petroff)

The original version of this article was published in International Advisor, which is part of the FT Group. 

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
Baillie Gifford Japan Ord709.00 GBX-0.14Rating
City of London Ord425.00 GBX0.24Rating

About Author

Jackie Beard, FCSI

Jackie Beard, FCSI  is Director of Manager Research Services, Morningstar EMEA

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