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Gearing: what makes investment trusts special (part 2)

The ‘Gavatar’ explains how the ability to borrow moderate amounts of money – or gearing – sets investment trusts apart from other stock market funds.

This is the fourth in a series of videos introducing investment trusts to investors.

Can’t watch now? Read the transcript

One big advantage investment trusts have over other investment funds is they can borrow money to invest.

This borrowing – or ‘gearing’ – means investment trusts can have more money to invest on behalf of their shareholders.

For example, if a trust raises 100 million pounds from investors and borrows 10 million pounds from the bank it has a total of 110 million pounds working for shareholders.

To put it another way, if I have 1,000 pounds invested in the same trust, the borrowing means the trust’s fund manager is deploying eleven hundred pounds into the stock market for me.

In this example the trust is 10 per cent geared as the 10 million pound loan is 10 per cent of the 100 million pounds the trust has in shareholder capital.

Provided the fund manager earns an investment return on the borrowed money that is more than the interest the trust pays on its loan, then the gearing should be good for shareholders. Assuming stock markets go up that is!

Over short periods of time gearing can make investment trusts riskier and their shares more volatile than other investments.

When markets rise, the share price of a geared trust will rise faster, which is good. But when markets fall, a geared trust’s shares will fall further, which can be alarming.

In the 2008 financial crisis when stock markets crashed some highly geared trusts ran into trouble because of this.

Over longer periods such as five or 10 years the effect of moderate gearing is usually positive. It is the main reason why investment trusts have generally outperformed other types of investment fund that can’t gear.

Investment trusts place strict limits on how much gearing their fund managers can use. A maximum of 25 to 30 per cent is common although in practice most trusts don’t go this high.

Trusts often vary their gearing according to whether their manager is positive or negative about stock markets. They will reduce or remove gearing when markets look expensive after a long rally and increase it when markets look cheap, for example after a sharp fall.

Investment trusts borrow money through an overdraft or a long-term, fixed rate loan which is the same as a mortgage but is called a debenture.

In the past some investment trusts borrowed when interest rates were high and struggled to make a good return on their loans. Recently interest rates have fallen very low enabling trusts to lock in cheap loans on which they should be able to make a decent return.

 

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