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Why Gear?

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26 May 2015

David Prosser takes a look at those companies taking on debt.

One reason why certain investment companies have been able to consistently outperform their open-ended rivals is that they are able to take on gearing: they can borrow money that can then be invested alongside their shareholders’ cash. The effect, in a rising market, is to soup up the returns generated by the fund.

The flipside, of course, is that gearing amplifies losses during periods when markets are falling. A fund with gearing is more risky - there is greater scope for volatility on both the upside and the downside – and this is one reason often given by independent financial advisers for feeling nervous about the investment company sector.

In which case, it may alarm some advisers to hear that a number of investment companies have been taking on new debt in recent times. Bankers Investment Trust, for example, has this month taken on £50m of new borrowings for a fixed term of 20 years, agreeing to pay 3.68 per cent a year in interest. RIT Capital Partners has also just concluded a number of placements, taking on £151m of debt at an average annual cost of 3.45 per cent. Witan Trust last month raised £75m of debt in two placements, at broadly similar rates. These funds follow the lead of several funds that took on new gearing last year.

Should advisers be concerned about this spate of borrowing? Well, the first point to make is that with the cost of debt still at rock bottom – courtesy of those all-time-low Bank of England base rates - these funds have been able to secure debt at really competitive prices. In the case of Bankers, once an existing tranche of debt is repaid on maturity next year, the average cost of its borrowing will have come down from 9 per cent a year to just 4.7 per cent.

It’s also worth pointing out that the cash does not have to be invested immediately. At Bankers, manager Alex Crooke expects to be fully invested by September, but he says he is waiting for signs of market weakness before deploying the facility.

This speaks to an important point about gearing: the fact that a fund has cash available to it does not mean the money will automatically be put into the markets. Where managers believe the time is not right for gearing, they have the option of pulling back, partially or completely – making such decisions, based on their view of the outlook for markets, is what investors pay them for.

However, remember why most investors put money into equities in the first place: they do so in the belief that as in the past, the stock market will outperform other asset classes over the longer term. If you take that view, it follows that gearing, over the long term, will enable a fund to do better than a rival that does not have any borrowings.

That, after all, is the trade-off all investors make. Gearing may indeed add to volatility, but the reward on offer for advisers and investors who are prepared to put up with the additional risk is the prospect of more attractive long-term returns.

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