Should advisers worry about gearing levels at investment companies?

Unlike open-ended funds, investment companies have the option of borrowing funds with the aim of enhancing returns – and new analysis from Winterflood Investment Trusts suggests the majority are doing just that, even in these turbulent times for markets.

Winterflood looked at 179 investment companies with exposure to equity markets and found that 104 of them currently have gearing in place – some 58 per cent. That’s marginally down on a year ago, when the equivalent figure was 63 per cent, but less so than you might expect given the uncertainties and anxieties that have stalked markets this year.

Nor have investment companies reduced the amount of gearing in place. The average fund’s gearing currently stands at 6.8 per cent.

The position varies a little from sector to sector. “The average net gearing in the UK All Companies sector fell from 7 per cent to 5 per cent over the 12-month period, while most UK Small Cap funds have reduced their net gearing,” says Winterflood’s Simon Elliott. “In contrast the UK Equity Income sector average net gearing increased; more than three-quarters of funds in the UK Equity Income sector are currently geared, compared with less than 60 per cent in the UK Smaller Companies and UK All Companies sectors.”

Elliott says he is surprised the figures haven’t changed more markedly over the past year given the headwinds we have seen buffeting markets for much of 2016. After all, while gearing enhances returns when markets are rising, it also accelerates losses during more difficult periods.

Some funds have deliberately chosen to take on long-term strategic gearing and to stick with it through thick and thin – and where their debt is arranged to maximise the long-term benefits, the costs of repaying it early, or restructuring, may be prohibitive. But other funds have shorter-term borrowing arrangements in place – more tactical gearing in other words – that is more straightforward to chop and change. Elliott thinks it is possible that some of these funds “could be more flexible in their tactical gearing”.

There will be some advisers – and investors – who feel the addition of gearing to a collective fund represents a ratcheting up of risk with which they are uncomfortable. And it is undeniably true that gearing will boost volatility – by definition, it exaggerates returns in one direction or another.

However, the rationale for investing in an equity market fund is that over the long term you believe equities are likely to outperform other types of assets, as they have tended to do in the past. If that’s not your view, why hold equities at all?

In which case, the argument for gearing – within the relatively modest ranges adopted by most investment companies – is compelling. If you think equities are going to go up over time, it makes sense to deploy all of the tools at your disposal to maximise the benefit you get from those gains, including gearing.

As for the question of tactical gearing, in part that comes down to your confidence in investment funds to call the market over short-term periods. And the reality is that very few managers have a good track record of consistently getting these day-to-day calls right – not least because they’re paid to be long-term investors rather than market speculators. In which case, the sensible option is to stick with the strategic approach.