Is gearing good to go?
David Prosser explains how gearing can turbocharge a fund’s performance.

The ability of investment trusts to take on borrowing is one of the attributes that makes them unique – other collective investment vehicles aren’t typically allowed to do this. And while such borrowing (or gearing as it’s known) can increase risk, it can also boost returns.
In a rising market, a fund with borrowing will outperform a fund that has no borrowing, even if both vehicles invest in an identical mix of assets. In simple terms, the geared fund is able to invest larger sums in these assets; once borrowing is repaid, the returns on it can be shared out amongst investors.
The flip side, naturally, is that when markets fall, gearing will exacerbate the fund’s losses. The borrowing still has to be repaid, even though some of it has been lost to market movements; the shortfall has to be made up from investors’ money, adding to their deficit.
In practice, investment trusts take on different types of gearing, with the impact on returns depending on the nature of the borrowing. And, of course, some funds choose not to take on gearing at all – or have gearing facilities in place but choose not to make use of them.
Still, the basic principle holds true: gearing helps a fund on the way up but hinders it in tougher times. Whether you want exposure to an investment trust with gearing therefore depends on your attitude to risk, and your views about the direction of financial markets.
Interestingly, several investment trusts have raised gearing levels in recent weeks and months. Research just published by the AIC highlights a number of funds in the UK All Companies and UK Equity Income sectors with gearing of 10% or more. It also features comments from the managers of three of those funds, Mercantile Investment Trust, Shires Income and Lowland Investment Company. All of them explain that their current levels of gearing reflect their optimism about the prospects for UK equities, given the economic backdrop and current valuations.
“There is certainly a growing feeling among UK fund managers that better times are ahead for the UK stock market, which has lagged other equity markets in recent times.”
David Prosser
Now, you may or may not agree with this optimism, but there is certainly a growing feeling among UK fund managers that better times are ahead for the UK stock market, which has lagged other equity markets in recent times. The FTSE 100 Index of blue-chip stocks is already trading at record highs, but there is plenty of room for the rest of the market to catch up.
It’s also worth thinking about why managers are upbeat about the economic outlook. One significant factor is that we are moving towards a period of looser monetary policy – nobody is quite sure when the Bank of England will cut interest rates, but the consensus view amongst economists is that we’ll get at least two reductions this year. That has the potential to reduce the cost of gearing.
None of which is to suggest that highly-geared investment trusts are suddenly about to start racing ahead. In the end, whether to put money into these funds is a matter of individual judgement. But what is definitely true is that if markets perform strongly, gearing can boost returns.