Structural benefits

Should we be worried about Scottish Mortgage Investment Trust? The top-performing investment company, best-known for its holdings in technology giants such as Amazon and China’s Alibaba, last week reported stellar returns for the year just gone, but now wants to take on more debt, despite having taken out £126m of loans last year. Is there something we should know?

Don’t panic. The debt Scottish Mortgage is talking about is gearing. This can be an effective way for investment funds to enhance returns – and it’s a feature that is unique to the investment companies sector since other types of fund don’t have the option of taking on gearing.

The theory is simple enough. A £100m fund, say, can become a £110m fund by borrowing money to invest in its chosen asset classes. As long as the investment returns earned on the borrowings are higher than the interest the fund has to pay its lenders, the effect will be to increase its total returns; and even when the debt is repaid, this excess return remains available to investors.

Used sensibly and competently, gearing is a powerful tool. It’s an important part of the explanation for why investment companies have consistently tended to outperform comparable open-ended funds, which don’t have the option of taking on gearing.

Still, there is a downside. During periods when the fund’s returns disappoint, gearing exaggerates the difficulty. Just as geared funds rise faster when the market is going up, so they fall harder when the reverse is true.

However, investment trust boards recognise this risk and seek to manage it by setting strict caps on how much gearing their managers may take on. A maximum of 25 per cent – meaning the manager can borrow no more than 25 per cent of the value of the fund – is pretty typical.

Often, managers don’t get anywhere near these maximums. At Scottish Mortgage, for example, the current gearing ratio is around 8 per cent; and across the rest of its sector, the average figure is more like 5 per cent. Managers take on various types of debt, including long-term loans, but try to make sure they have some flexibility to easily vary their borrowing; they can then reduce or increase gearing according to their views about the outlook for markets.

As a general principle, however, maintaining a consistent level of long-term gearing make sense, particularly since the cost of borrowing, with interest rates at historic lows, has been so affordable in recent years. If you’re invested in financial markets, you’re presumably expecting them to rise in value over time. In which case, gearing should provide additional rewards.

While we’re talking about Scottish Mortgage, one other aspect of last week’s results announcements was noteworthy. For the first time, the fund is financing some of its dividend payment by taking profits on a part of its portfolio, rather than meeting the cost of the income distribution from the income its investments generate.

This is another flexibility open to investment companies that isn’t a possibility for other types of collective vehicle. It provides a means for funds heavily invested in growth-oriented companies which may not be paying dividends to ensure they are still able to make a distribution to shareholders.