Geared up

David Prosser explores how investment companies using gearing have been able to take advantage of market downturns.

gears

As so very often, Warren Buffett puts it best. His advice to investors is to be “fearful when others are greedy, and greedy when others are fearful”. To put that another way, buying stocks when markets are racing ahead can be to set yourself up for a fall; and not buying when markets take a tumble may be a missed opportunity.

While it is easy to get sucked into the madness of the crowds, one would hope that the investment professionals who run collective funds on our behalf are practising what the Sage of Omaha preaches. And in that regard, research just published by Investment Week magazine, based on some number-crunching by the Association of Investment Companies, makes fascinating reading. It highlights a number of investment companies that have been borrowing money to take advantage of the market downturn of recent weeks.

Remember, one unique feature of investment companies is that they are allowed to take on gearing – to borrow additional funds to invest alongside the capital put up by shareholders. The effect is to supercharge returns – in either direction; an investment company with gearing in place will outperform when the market is rising and underperform when the reverse is true.

Since markets tend to rise over time, investment companies’ ability to take on gearing is often cited as a key driver for the fact that on average at least, they tend to outperform comparable open-ended funds, which are not allowed to borrow. Still, gearing must be used sensibly – deployed when the manager thinks it will have maximum positive impact.

If you buy Warren Buffett’s advice, now might be one of those times. The market as a whole is certainly feeling fearful; bad economic news, geopolitical uncertainty and pandemic-related disruption have combined to undermine pricing. That surely creates the right kind of environment for smart investors to go bargain-hunting.

Eight investment companies identified in Investment Week’s research appear to be doing exactly that. Each of them raised their gearing by at least three percentage points over the four months to the end of April, while also increasing the value of their debt in cash terms by at least 20%. In most cases, these funds are drawing down on borrowing facilities they already have in place, enabling them to exploit opportunities created by the volatile market conditions.

Will this opportunism pay off? Well, only time will tell, but this is a classic example of where a combination of the investment company structure and a skilled management has the potential to create additional value for investors. The contrast with open-ended funds is striking here. Their managers may also recognise value opportunities in the current market conditions, but they don’t have access to borrowing facilities.

Indeed, since market downturns often prompt investors to sell their fund holdings, many open-ended fund managers may actually be having to liquidate assets to meet redemptions, rather than searching for value in new positions.

Gearing, it should be recognised is not without risk. Get it wrong and investors’ losses will be magnified. Still, this is a tactic that most funds deploy only sparingly – as the AIC points out in Investment Week’s research, around half of investment companies currently have no gearing at all, and average gearing in the sector rarely gets above 10%.

Moreover, investors and their advisers should only be considering stock market investments if they’re in it for the long haul – and if they also accept the received wisdom that equities will outperform other asset classes over these extended periods. In which case, the case for prudent gearing is a strong one.