David Prosser considers investment companies' use of gearing and why investors should not be afraid of it.
Investment companies are borrowing more money. Edinburgh Investment Trust has just revealed the detail of a series of private placements – long-term unsecured loans – worth £120m. The borrowing, repayable on dates between 2037 and 2057, is the latest in a series of placements unveiled in the sector, with Monks, Bankers, City of London, BlackRock Smaller Companies and a number of real estate investment trusts all making similar announcements in recent months.
One driver of this trend is that borrowing is currently cheaper than ever before. Edinburgh’s new facilities come with an average interest rate of 2.44%. It will use £100m of the borrowing to repay a previous debenture costing 7.75% a year, saving itself £5.3m a year in interest costs.
Still, even after making that repayment, Edinburgh will have £20m of additional firepower. It is a reminder that gearing is a point of competitive differentiation for the investment companies sector – no other type of collective investment fund is allowed to borrow money in order to invest.
In practice, investment companies exploit that advantage in different ways. Some focus on structural gearing, arranging long-term borrowing facilities so they can maintain gearing over the longer term. Others are more tactical, deploying gearing to a greater or lesser extent depending on their view of the market outlook. A combination of both approaches is common.
Advisers and investors sometimes worry about this. While gearing enables investment companies to outperform in rising markets – when the borrowing provides an accelerator effect on investors’ funds – the opposite is true during periods of market decline. All other things being equal, a geared fund will lose money more quickly than a fund with no borrowing when portfolio values tumble. In other words, gearing makes an investment company more volatile.
Such concerns are understandable, but given that investment companies have exclusive rights to this potential performance enhancement tool, it would be peculiar if they didn’t choose to take advantage of it. Besides, anyone choosing to put money into an investment fund presumably expects that fund’s assets to rise in value over time, rather than to fall; in which case, the net effect of gearing will be to boost returns, rather than to depress them.
The data suggests – at least for historic performance – that this is what has tended to happen. Studies repeatedly show that investment companies, on average, have outperformed other types of investment fund when fishing in comparable pools of assets. The fact investment companies have taken on gearing explains a significant proportion of this outperformance.
It is also important to recognise that most investment companies deploy gearing with caution. Indeed, investment company managers have become more conservative over time. Across the investment company industry as a whole, gearing currently averages 7% - that is, the typical fund has borrowings worth the equivalent of 7% of their assets. A decade or so ago, the figure was more like 16%.
That reduction reflects the uncertainties of the past ten years, spanning the impact of the financial crisis, the anxieties of Brexit and the Covid-19 crisis. Markets have risen over the period, but with plenty of volatility, and investment company managers have therefore been careful with their borrowing strategies.
This is what advisers and investors should want from their managers. Deployed judiciously, gearing can add value, so it should not be something to be afraid of; indeed, funds should be encouraged to explore their options. All the evidence is that investment companies are doing exactly that.