Introduction to Investment Trusts - 'Gearing' Explained

What is gearing?

Gearing is the process whereby an Investment Trust (IT) borrows money in order to reinvest it. The money that is borrowed is invested in shares and other securities in an attempt to maximise the gains made by the Investment Trust. Unit trusts cannot do this.

Investment trusts also have the ability to use derivatives to increase exposure to stocks and effectively gear the portfolio. Derivatives are used as a way of gaining exposure to the price movements of shares without buying the underlying shares directly.

When the stock market is healthy and rising Gearing can be very effective as the gains made by the IT will be maximised. When stock markets are falling, Gearing will accentuate losses of the IT due to the increased exposure.

A trust with a high level of gearing - i.e. a trust which has borrowed a larger amount of money or has increased its exposure to stocks via derivatives - would potentially fall further when markets are performing badly than trusts with low gearing, to the detriment of investors. However when markets are performing well, a highly geared trust has the potential to make higher returns. Please do remember that the value of investments can go down as well as up and you may get back less than you invested.

What are the benefits?

Gearing can be a very effective means of increasing the gains made by a successful Investment Trust when stock market conditions are positive. The borrowed money or derivative increases the amount that can be invested in the stock market and as such can lead to increased returns.

What are the risks?

When stock market conditions are negative and share prices falling Gearing will increase the potential for losses. This is because the amount invested on the stock market will be greater than the original value of the IT due to the borrowing and will become over-exposed to falling share prices should the market experience a downturn.

What is a gearing factor or rating?

A gearing factor or rating is an indication of the level of gearing of a particular IT. For example, a gearing factor of 100 means the trust has no borrowing whereas a rating of 110 means the trust has gearing of 10% of total assets. As such a gearing factor of 120 means that on a trust with equity of £100 million it is £20 million invested above the original value of the investment. In these two circumstances, the IT's gains or losses will be magnified by 10 or 20 per cent respectively.

Can I see an example of the effect of Gearing?

If an IT valued at £20m borrows or uses derivatives to gain equity exposure totalling a further £5m, it has £25m invested. If the underlying investments rise by 20%, the fund would be valued at £30m. £5m is still owed, giving a net value of £25m, an increase of 25%. If instead the underlying investments had decreased by 20%, the net value would have been £15m - a loss of 25%. The figures presented above are hypothetical and the important point to consider is that gearing makes the Investment Trust potentially more profitable but also increases the exposure to the risk of making losses.

Managing the risk of Gearing:

Well managed ITs ca take steps to manage the risks of gearing and to help conserve capital.

The money that is borrowed to bolster the Investment Trust does not have to be invested in equities. If the equity market has a negative forecast then the borrowed money can be held either as bonds or in cash. Alternatively they can be invested in other asset types such as property. This will serve to "hold the cash" until the market outlook improves.

If the outlook of the market deteriorates further Investment Trust managers can even embark upon the process of de-gearing whereby a greater amount of equities than the amount borrowed are sold and the proceeds held as cash.

Conclusion:

It can be seen that Gearing can have a substantial effect upon the performance of an Investment Trust . When markets are positive it has the potential to significantly increase the level of return seen by a particular Trust.

The successful management of borrowings and the subsequent gearing is vital in order to achieve greater returns in a way not available to open-ended funds for example. However, it is prudent to remember that when markets are falling gearing creates greater levels of risks and the Investment Trust can experience significant losses. This means that investment trusts are potentially more volatile than the equivalent unit trust.

Not all ITs engage in gearing and details of a specific trust's gearing can be obtained from the Association of Investment Companies (AIC) to ensure that the level of risk is acceptable to the individual investor.