Getting in gear

Amid an impressive set of results published by Merchants this month, the investment company’s update on its gearing made interesting reading. Merchants explained it has just borrowed £42m in a three-year revolving credit facility in order to repay the last of a series of expensive fixed-rate loans it took out in the 1990s. The mechanics of the arrangement are a little complex but should boost Merchants’ earnings per share by 2.6p – potentially paving the way for higher dividends – while maintaining the fund’s gearing levels at around 16%. That’s double its sector average.

Gearing is a subject that polarises financial advisers. A couple of years ago, an Association of Investment Companies survey found 40 per cent of advisers are put off investment companies by the fact they have the ability to take on gearing. Others, however, regard this as a unique selling point for the closed-ended fund industry, with other types of collective investment fund not able to borrow money.

The maths of gearing is simple enough. In a rising market, the effect of borrowing money to invest is to boost the returns the fund achieves – gearing offers a performance super-charge. The flip side is that the same effect is seen in reverse when markets are falling. Geared funds will lose out more heavily when asset prices drop, all other things being equal.

In that sense, gearing increases risk. An investment company with gearing will produce more volatile returns during the same market conditions than a fund that doesn’t have any borrowing.

This, of course, is what some advisers feel uncomfortable with. But there are a couple of important points to make here. The most fundamental is that if an adviser doesn’t expect markets to rise over the longer term – and therefore for gearing to work to clients’ detriment – why invest at all?

Second, underlying the theory of gearing is the practical reality that investment company managers have operational control over how borrowing is deployed. When in cautious mode, they may choose not to invest their additional financial firepower, or to hold more cash, mitigating the risks about which advisers are worried.

In fact, this is another example of how investment company managers embrace more active styles of portfolio management. One criticism often laid at the door of the funds industry is that too many managers are effectively running passive funds that mirror the markets closely, while charging much higher fees than outright index trackers. That’s rarely the case in the closed-ended sector.

Naturally, investment company managers sometimes make the wrong call on when to deploy gearing. In aggregate, however, the fact around half of all closed-ended funds have at least some borrowing on their balance sheets has been a very significant part of the explanation for why the sector has outperformed over the longer term.

In simple terms, if you buy the argument that the stock market tends to outperform other types of asset over longer-term periods, the upside potential of gearing is what you should be focusing on. It’s certainly worked for Merchants, which has a track record of consistently strong performance.