David Brenchley
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Updated 10 Nov 2024
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This is not substantive investment research or a research recommendation, as it does not constitute substantive research or analysis. This material should be considered as general market commentary.

Our latest jargon buster will aim to explain what gearing is, how investment companies use it and the potential impact it can have on returns.

The ability to use gearing is one of the many aspects of the investment company structure that makes the trust world so unique from the open-ended funds universe.

At its simplest, gearing is an investment trust’s ability to borrow money from a bank to buy more assets than it would otherwise be able to buy.

If the assets the trust buys with its borrowings do well, gearing can enhance the performance of the investment trust, giving shareholders a kicker to returns. If the assets perform badly, shareholders will face greater losses than they otherwise would have if gearing hadn’t been employed.

The hope is that the use of gearing will pay off by securing the trust a higher return than the interest that it is paying the bank that gave it the loan.

The minimum and maximum level of gearing that an investment trust can employ is set by the trust’s board and approved by shareholders. The investment manager controls and implements the level of gearing the trust employs.

Some trusts use structural gearing, which means they are permanently geared. Others use gearing tactically, so when the investment manager is feeling particularly bullish, they might increase gearing; if they think that valuations are stretched, they might decrease it.

Fidelity Special Values (FSV) is a good example of tactical gearing. The board’s policy allows for a maximum gearing level of 40% of net assets, but as you can see from the chart in the latest research note, it’s not been above 25% in the past five years and the five-year average is c. 9.5%.

Generally, the interest rates on offer to trusts are much lower than those offered to individuals looking for loans. Still, as with individuals’ loans, the interest rates on offer were much more attractive when interest rates were near-zero than they are today. The trusts that locked in fixed, long-term debt at somewhere around 2% or so will have an advantage over those looking to take on new debt now.

For some trusts with structural gearing, rising interest rates have been a headwind. Once their low-cost debt runs out, if they need to renew their loans at higher rates of interest it could mean lower returns for investors, or potentially a cut in the dividend in a worst-case scenario. You can find out more on gearing in this blog.

How gearing works

A trust with net assets of £100 million and zero gearing would be able to invest £100 million. The same trust with 10% gearing would be able to invest £110 million.

Let’s say that gearing is a one-year facility at 2% interest, at the end of which period the trust’s investment portfolio has grown 20%. At the end of the term, the trust must repay the bank the £10 million it borrowed, plus the £200,000 in interest.

The new net assets are now £121.8 million, as opposed to the £120 million they would have been had gearing been zero.

On the other hand, if the portfolio had fallen 20%, the net assets after the loan and interest had been repaid would be £77.8 million, as opposed to £80 million with no gearing.

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