Investment companies can borrow money to make additional investments (gearing). If markets do well, this can improve returns, but when they fall, the loss will be greater than it would have been in an ungeared fund.
Gearing is best seen as a tool that investment companies can use. It can help them improve long-term total returns as well as the level of income they can offer, but it also increases volatility and risk.
Not all investment companies use gearing and most use only modest levels. The average level of gearing of all investment companies, calculated as borrowings divided by net assets, was 7% at the end of September 2021.
Instead of borrowing money, investment companies can gear by using derivatives, or by issuing debentures or zero dividend preference shares. All these are included in the AIC’s methodology for calculating gearing.
Gearing and client suitability
The AIC encourages investment companies to provide a ‘gearing range’, which indicates the minimum and maximum levels of gearing that a company’s board would expect it to have in normal market conditions.
For example, a gearing range of 0/25 would mean the company would normally have gearing of between 0% and 25%, though in exceptional circumstances (for example, a sudden and severe market fall) it might temporarily be higher.
The gearing range is useful when considering if an investment company could be a suitable investment for a particular client.
For each AIC member company, the current level of gearing and the highest and lowest levels of gearing over the previous three years (‘historic gearing’) can be found on this website, as well as the gearing range, if the investment company has provided one.
Zero dividend preference shares
Issuing zero dividend preference shares (also called zeros or ZDPs) is one of the ways in which an investment company can gear. From the perspective of ordinary shareholders, the zeros have a very similar effect to borrowing, and they are included in the AIC’s methodology for calculating gearing.
Holders of zeros receive no income, only a capital gain in a set number of years. This is a fixed gain (though not guaranteed) and takes priority over the claims of other shareholders.
For example, an investment company may raise £100 million by issuing 100 million zero dividend preference shares at 100p per share. The zeros have a fixed life of seven years, after which they mature, paying fixed proceeds of 130p. Assuming the zeros are repaid in full, the investment company pays back £130 million and all the zeros are cancelled.
Zeros may be useful for clients' tax planning, because they pay no income. More information on zeros can be found within the ZDP analytics section of the AIC’s website.