Looking at leverage

To what extent has investment companies’ gearing given rise to losses over the past two months of Covid-19 pandemic-induced market disruption? It’s a valid question: those who worry that closed-ended funds expose investors to risks they don’t face elsewhere are entitled to ask whether gearing has caused additional problems in the investment company industry.

After all, gearing is a unique feature of investment companies; for some investors and advisers, it’s part of the attraction, but for others, it gives cause for a concern. Unlike other types of collective investment funds, investment companies can take on borrowing and invest the debt in their portfolios; such gearing boosts returns in a rising market, but when prices fall, it exaggerates the loss.

It’s worth saying upfront that very few investment companies maintain significant levels of gearing. The Association of Investment Companies’ data reveals that the average fund had borrowings valued at the equivalent of just 7% of their assets at the end of March. Many funds had no gearing at all.

Still, even modest borrowing adds to the risk profile of a fund, increasing its potential for volatility. And in extreme circumstances – such as the events of the past few weeks – this potential will naturally be amplified.

Against that, investment company sceptics often overlook an obvious point. Fund managers can – and very often do – vary their gearing levels according to prevailing market conditions and their view of the future.

Research from Winterflood suggests this is exactly what many managers have been doing in recent weeks. It looked at a sample of 183 funds with average gearing of 5% at the end of January. A fifth of these funds reduced their gearing during the market’s dislocation; the number that have no gearing at all now is now close to four in 10.

In fact, this represents a continuation of a previous trend. Many investment companies were reducing gearing even before Covid-19 struck, amid anxiety that the prolonged equity market bull run was running out of steam, particularly in the US. Around 100 funds reduced their gearing levels last year according to the fund analyst Morningstar.

What we’ve seen here, in other words, has been prudent trimming of borrowing to reflect generalised concern about valuations, followed by more decisive action in the face of a specific threat. As a consequence, the losses that investors will have suffered as a result of their funds’ geared positions will have been reduced.

This isn’t to suggest investment companies have all played the perfect hand during this crisis. The reality of gearing is that timing decisions about borrowing is as difficult as timing the market itself. Effectively, it’s the same judgement call.

However, it’s worth remembering that while gearing will have exaggerated some funds’ losses during the recent downturn, it’s also been an important part of the explanation for the industry’s collective outperformance of other types of fund over the long term. If you believe markets will rise over time – which you presumably do if you’re prepared to invest in them – the implication is that you also believe exposure to gearing will do you more good than harm.

In that regard, it will be interesting to see how managers approach gearing in the weeks and months ahead. Increasing borrowing once again might be considered a brave move given all the unknowns remaining about Covid-19. But it’s difficult to imagine how debt will ever be cheaper than it is today, so gearing up in order to benefit from a hoped-for recovery could well prove smart as well as courageous.