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What are the effects of gearing?

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7 January 2016

David Prosser takes a closer look at the long-term effects of gearing.

Gearing is one issue often cited by financial advisers who remain cautious about recommending investment companies to clients. Closed-ended funds have the ability to take on gearing – and many do so – which can boost their returns when asset prices are rising, but can also exacerbate losses when markets fall. Some advisers do not feel comfortable with the additional volatility this might represent.

That’s not unreasonable, but it’s worth thinking in more detail about this issue. For one thing, most investment companies are relatively long-term holdings for clients, chosen, presumably, for their ability to add value over an extended period, rather than in anticipation of loss. If you’re working on the basis of achieving a positive return over the long term, gearing will be a help rather than a hindrance.

Moreover, investment companies don’t automatically take on gearing. The ability of managers to do so will be clearly set out in the investment mandate handed down by the board – individual funds then take a strategic view about when to exercise this mandate. This is one element of the professional expertise for which investors are paying when buying into the fund.

The other interesting point to make about gearing is that, in the current low interest rate environment, it has rarely been so affordable. Research published this week by the credit ratings agency Fitch suggests the weighted average cost of debt in UK investment companies now stands at just 3.7 per cent.

In the past, investment companies tended to take on gearing via instruments such as debentures and preferred shares. In more recent times, however, they’ve shifted to short-term bank loans and notes, priced at rates that reflect the current interest rate climate.

Unwinding previous gearing commitments takes time, since it is often expensive to call in long-term debt early. But with base rates having stayed so unusually low for such an extended period, investment companies have slowly but surely been able to shift their gearing profiles. Fitch says investment companies still pay rates ranging from 50 basis points a year to 14 per cent (28 times’ as much), but the move towards cheaper debt has brought down the average.

It also helps that investment companies’ assets under management have grown so steadily over the past three years – thanks both to new issuance and rising asset values – which has brought the cost of servicing existing debt down in relation to assets under management. Indeed, Fitch points out that despite a marked increase in debt issuance during 2015, investment companies’ “leverage ratio remained broadly stable due to growing assets under management”.

None of which is to suggest that financial advisers should simply disregard gearing. The ability of closed-ended funds to take on debt is an additional issue that both advisers and investors should consider when looking at investment companies. Volatility may be an issue for some clients.

Nevertheless, the long-term effects of gearing should be beneficial for investors in rising markets – which is what advisers recommending all collective funds are expecting. And given that the cost of gearing is now so low for many funds, their efforts to deliver those benefits will be considerably less expensive.

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