Time for a shift of gear?

Investment companies are the only type of retail investment fund permitted to borrow money in order to increase their investment exposures. This is important because when asset prices rise, that gearing gives the investment company’s performance an extra boost.

Analysis published in recent days by Investors Chronicle therefore makes fascinating reading. It points to a group of ten investment companies that have increased their gearing in recent months. Examples range from UK-focused funds such as Mercantile and CT UK High Income, to less mainstream vehicles including Premier Miton Global Renewables and Henderson Far East Income.

Now, the thing about gearing is that it’s a two-way street. In a rising market, it will supercharge returns, but when asset prices fall, gearing will add to losses.

Still, if you’re investing in the stock market, or any other asset for that matter, you presumably think that asset prices will rise more often than they fall over longer periods. In which case, a fund that carries some gearing should be a net positive for the value of your investments, even if there is a little more performance volatility along the way.

Indeed, that has been the case, at least in aggregate. In most sectors of the market, investment companies have a long-term track record of outperforming other types of collective fund but have often been more volatile over shorter periods. The impact of gearing is a large part of the explanation for that profile of returns.

Coming back to the present day, the fact that investment companies feel confident enough to raise their gearing levels is encouraging. It suggests that managers think global markets can put some of the travails of the past two years behind them; perhaps a sustained recovery is not so far away.

There’s also the issue of interest rates to consider. Many funds have longstanding borrowing arrangements, often agreed at the bargain-basement rates that were on offer until inflation prompted central banks to start increasing the cost of borrowing from 2022 onwards. This gearing can be deployed as managers see fit. In other cases, however, managers will take on new borrowing – that may become more common if, as some economists now expect, we have reached the top of the interest rate cycle, and the cost of debt begins to come down.

Either way, investment companies’ gearing costs today look pretty low by historical standards. That provides the sector with an opportunity to exploit a competitive advantage – and for investors to reap the rewards once markets finally make a decisive move back into more bullish territory.

Let’s not go overboard. Investment companies are usually quite restrained about their use of gearing. AIC statistics show that where funds do use gearing, they typically keep it in single percentage points in terms of its value compared to the portfolio. That offers a sensible compromise – the opportunity to take advantage of gearing but not a gung-ho approach that risks significant downside.

Still, don’t overlook those long-term performance numbers. If gearing has been such an integral part of investment companies’ strength in the past, the effect can be repeated in the years ahead. It’s another reason, all else being equal, to consider investment companies for exposure to a particular asset class ahead of other types of collective funds.