How Gearing Boosts Profits

Investment trust managers have tools to boost performance not available to their open ended fund manager peers. Here we explain how gearing can mean big profits

Jackie Beard, FCSI 26 November, 2013 | 8:00AM

Gearing is one of the tools that an investment trust has in its toolkit that, in its traditional sense as a loan, isn’t available to its open-end peers. It tends to provoke a marmite reaction, though—investors either love it or hate it. If used well, gearing can generate extra returns, but used poorly, or when markets are heading south, it can exacerbate losses.

Gearing has garnered something of a tainted reputation. In the 1990s, some trust boards took out long-dated, fixed-term loans to provide long-term, structural gearing for their funds, underpinned by the belief that the returns from equities over the long term would beat those of other asset classes, including cash. For example, in 1991 we saw the board of Witan Investment Trust secure 25-year debt at 8.5%; with the Bank of England base rate well into double figures, on a relative scale that looked attractive. Bankers, City of London, Keystone, Scottish Mortgage, Edinburgh Investment Trust and Merchants Trust all negotiated similar arrangements. But by the mid-Nineties, rates had come down to nearer 6% and by the turn of the century, they were sub-5%.  That meant the boards were saddled with expensive debt and the investment managers had to do a fair amount of running just to keep still in their portfolios. Shareholders saw muted returns on their investments because of the scale of the interest payments in servicing that debt.

Of course, no-one expected to see the Bank of England keep rates at less than 1% for four years. So those trusts with expensive, long-dated debentures face an uphill battle to generate returns that beat the cost of servicing that debt—and in all those funds mentioned above, that’s still the case today as the debentures have yet to redeem.

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About Author

Jackie Beard, FCSI

Jackie Beard, FCSI  is Director of Manager Research Services, Morningstar EMEA

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