Getting in gear (2017)

With the Bank of England just having raised interest rates for the first time in a decade – and predicting further increases to come – time may be running out to take on new borrowing at very low cost. Some funds in the investment companies sector appear to have reached exactly that conclusion in recent weeks. Merchants Trust and Temple Bar, for example, have both raised new debt over the past fortnight.

These funds are effectively locking in the low cost of borrowing while they still can, taking the view that the expense of servicing the debt will be more than compensated for by the investment returns they can earn on the money. You can see the argument: Merchants and Temple Bar are paying fixed interest rates of 2.96 per cent and 2.99 per cent a year on their debt; both will hope to earn substantially higher annualised returns on their portfolios in the years ahead.

If so, the funds’ borrowings will effectively super-charge their performance. This is the point of gearing up in this way – a fund with gearing worth 10 per cent of its assets earns an additional 1 percentage point of return for every 10 per cent of positive performance it achieves.

Nevertheless, financial advisers often worry about gearing. Research published by the Association of Investment Companies last year found that 40 per cent saw gearing as a reason to think twice about investing client money in closed-ended funds. Their fear is that gearing raises the risk profile of a fund – while borrowing enhances returns during a period of rising markets, it exaggerates losses when asset prices are falling. That same fund with 10 per cent gearing will also lose an additional 1 percentage point for every 10 per cent fall in its asset value.

Are advisers right to be anxious about gearing? Well, there is no right or wrong answer – much will depend on the appetite for risk of the client on whose behalf the investment is made.

However, it’s worth pointing out that investment companies are generally pretty conservative in their use of gearing. The average closed-ended fund holds a gearing position of just 6 per cent today according to the AIC, which looks modest given the cost of debt.

Also, the fact that an investment company has taken on gearing doesn’t mean it is required to deploy the borrowing in the market; it can choose to hold some of the money in cash. In this context, it’s important to understand the difference between a fund’s net and gross gearing position – the extent to which it has invested the debt finance it has raised.

Naturally, this differential will change over time according to the view that the fund’s manager currently holds about the outlook for the portfolio and the broader market. And this is what investors are paying for through the charges levied by an actively-managed investment fund – the manager’s ability to make the right decisions about asset allocation.

In the end, the ability to take on gearing is one of the unique selling points of an investment company – no other collective investment vehicle is able to borrow in this way. When funds get it right, gearing can be a real bonus for investors; so for those advisers with clients for whom taking this calculated risk is acceptable, the sector’s current embrace of low-cost borrowing is to be welcomed.