Gearing up for growth

Should investors worry about investment company gearing now that interest rates have risen so significantly – and may rise further? It’s a valid question: when investment companies borrow money, there is the potential for a boost in returns, but the value of any gain will inevitably be undermined to some extent by the cost of the debt.

This is a conversation that we had almost forgotten about – for more than a decade following the global financial crisis of 2008-09, interest rates remained at bargain-basement levels. The cost for an investment company of taking on debt was negligible.

In the past two years, however, as inflation has spiked, the environment has dramatically changed. The Bank of England has now raised interest rates on 14 separate occasions since December 2021. Economists are split on whether there are further rate rises to come – or how many – but the Bank’s base rate has already risen from just 0.25% to 5.25%.

Naturally, that has implications for investment companies, which are the only type of popular collective investment fund allowed to take on gearing. This unique ability is an important part of the explanation for why investment companies, on average, tend to outperform other types of funds over longer-term periods. But if the cost of debt gets too high, investment companies may no longer feel comfortable about borrowing.

The good news is that we are not at that point yet. For one thing, a large chunk of investment company borrowing is “structural” gearing. This is borrowing arranged over an extended period to give the investment company an ongoing gearing position; very often, this debt is priced at a fixed rate of interest, so in most cases what investment companies are paying today will not reflect the rises in interest rates seen over recent months.

A second type of gearing, meanwhile, is known as “tactical”. This is borrowing that managers take on, typically for shorter periods, as they see fit. Their decision will depend on their view about the prospects of the markets in which they invest, but also on the cost of borrowing at the time and in future, since interest rates are more likely to be variable. If managers think they can generate sufficient returns, they will continue to borrow in this way.

Remember, too, that most investment companies are cautious about gearing. Very often, the manager operates according to strict guidelines that set a maximum amount of gearing they can take on. This limits downside risk. Funds with the option to gear don’t have to do so.

Another important point is that if a manager becomes concerned about the fund’s gearing position – either because of higher borrowing costs or the broader market backdrop – there are mitigations that can be put in place. It may not be possible to unwind the debt, but managers can move assets into cash; effectively, that reverses some of the gearing on the fund.

There are no absolute answers here. Different investment companies operate with different approaches to gearing – and do so within different guideline set by the fund’s board. Certainly, there are risks to take into account, alongside the opportunity for enhanced returns potentially available from a geared portfolio; investors should take both the current level of a fund’s gearing and its gearing policy into account when doing due diligence on funds.

Overall, however, investment companies’ ability to gear remains a positive, even in the current interest rate environment. Smart managers able to exploit this opportunity will add value. At least, that is what the evidence of the long-term performance data suggests.