What is Gearing?

Ask the Expert: Morningstar analyst Jackie Beard explains what gearing is in an investment trust, and highlights which fund managers use it effectively

Emma Wall 25 October, 2013 | 7:00AM
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Emma Wall: Hello, and welcome to the Morningstar series, Ask the Expert. Today, we're focusing on gearing and here to discuss it is Jackie Beard, Morningstar analyst.

Hello, Jackie.

Jackie Beard: Hi, Emma.

Wall: So, there are number of instruments that closed-ended funds can use that open-ended fund managers can't, and one of these is gearing. What exactly is gearing?

Beard: Well, very simply, gearing is the ability to borrow money to invest that money on behalf of your shareholders. Because the trust is a company it operates under company law and just like any other corporate entity can go and borrow money.

The one thing to be careful of, of course, is that managers should only be using it where they think they can make more than the cost of servicing that debt. So, they've got to have pretty high conviction in the markets to be able to invest it for their shareholders.

Wall: It sounds like that can exacerbate losses as well as increase performance then?

Beard: Absolutely. So, when it’s good, it's very, very good. And when it's bad, it can be horrid. 

Wall: Are there any examples where perhaps gearing has worked against the fund manager?

Beard: So, one very good example is Invesco Leveraged High Yield (ILH). The clue is in the name. It's leveraged and it is high yield debt. So, in 2008 this fund had really a quite tough time and we all know what happens to the high yield market then; values were plummeting, the fund was well over 50% geared, and it got to the point where in October or November that year, they had to do a rescue rights issue because they were in danger of the fund basically imploding.

That's not to say that it was a bad use of gearing, but it's a good example of when – if markets go against you, it can be quite nasty. Now, to be fair, although they lost something like 60% that year, the following year they made about 130%, but the bottom line is that's not the kind of returns profile that an investor expects when investing in high yield debt. So, even you need to look at the risk return reward that you are getting.

Wall: Are there any examples where gearing perhaps has produced more consistent returns?

Beard: So, one very good example is Baillie Gifford Japan (BGFD); Sarah Whitley. It's quite a challenging market to make money in the last 20 years, apart from the last year or so. Sarah has consistently had gearing in the fund. She has used it exceptionally well. She hasn't produced a very high risk profile, but the risk return stats have been excellent. So, she's made money in years, for example, where the markets gone down, and yet she has managed to produce positive return for her shareholders. So, that's really good use of gearing where it really has added value.

Wall: And another example?

Beard: So, slightly different one is JPMorgan Claverhouse (JCH). Last year, they had a bit of a change to their portfolio strategy. So, William Meadon joined Sarah Emly, as the co-manager, and the Board's view there is that 10% geared is their neutral position. And what they've done is they've given William parameters around which to flex that gearing, so he can move it as he sees fit. To be very sort of short-term tactical moves, he is part of the asset allocation committee, so he is taking those views from JPMorgan down. He is really flexing it and moving it around quite a lot, but it's very short-term and it's very controlled. So you're not going to see wild swings, but you will see him move it. It's only been a year or 18 months in operation, but so far he is doing quite a good job.

Wall: Jackie, thank you very much.

Beard: Thanks.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Baillie Gifford Japan Ord715.10 GBX-0.40Rating
JPMorgan Claverhouse Ord724.53 GBX0.91Rating

About Author

Emma Wall  is former Senior International Editor for Morningstar

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