11 investment trusts aiming to take advantage of stock market falls

Over the long run, gearing tends to boost investment trust returns. Kyle Caldwell runs through those trusts that are upping gearings levels in an attempt to ‘buy low’.  

The first half of 2022 served as a reminder to investors that one of the structural differences of investment trusts over open-ended funds is a double-edged sword.

Investment trusts are allowed to gear, or borrow, to invest. This can improve their performance, but means they tend to be more volatile than their open-ended peers when stock markets are out of form.

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In the turbulent first six months of 2022, investment trusts performed worse than similar open-ended fund strategies. Analysis by interactive investor of 10 pairs of similarly managed investment trusts and funds showed that in the first six months of the year just two trusts performed better than their open-ended rivals.

On a sector level, there’s also a notable performance gap. Year-to-date, the average global fund has fallen by 6.3% versus a decline of 16.2% for the average global investment trust. It's the same story for UK equity strategies, with the average trust down 22.1% compared to a loss of 8.9% for the average fund.  

Over the long run, gearing tends to be beneficial and it is one of the reasons why trusts tend to have the upper hand over funds. However, it depends whether gearing is used successfully by the fund manager, in addition to stock markets generally moving upwards over time.

When stock markets are volatile, fund managers running investment trusts have a difficult decision to make; they can boldly attempt to ‘buy low’ by increasing gearing levels, keep the lever at the same level, or reduce or turn off the borrowing taps.

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On the whole, data from the Association of Investment Companies (AIC) for interactive investor indicates that trusts increasing gearing levels are in the minority.

But it is important to be careful with gearing data, as it is calculated by comparing a trust's borrowing against the value of its assets. When a trust's portfolio rises in value, its gearing will therefore fall, all other things being equal. By the same token, if the portfolio loses value, gearing will rise.

With this in mind, the AIC added a criterion to ensure the trusts identified had actually increased their borrowing in pound terms, rather than just seeing a percentage increase in gearing, which could have resulted from a fall in net assets.  

The AIC identified trusts that had, from the start of the year to the end of June, increased gearing by at least three percentage points, and also saw borrowings in pound terms increase at least 20%.

Overall, 11 investment trusts across a range of sectors were identified by the research.

Three Baillie Gifford-managed trusts have been extending their gearing: Scottish Mortgage (LSE:SMT), Monks (LSE:MNKS) and Edinburgh Worldwide (LSE:EWI). Their share prices have come under the cosh year-to-date, with high levels of inflation harming growth companies.

Other trusts that have seen their short-term performance sour and which have been upping gearing are: Montanaro European Smaller Companies (LSE:MTE), Geiger Counter (LSE:GCL), Henderson European Focus Trust (LSE:HEFT), International Biotechnology (LSE:IBT), and Bellevue Healthcare (LSE:BBH).  

Increases in gearing reflect an optimistic view of the area the investment trust invests in. Therefore, those 11 trusts identified by the AIC will be hoping on a three- to five-year view that they will be rewarded for ‘buying low’ if markets recover their poise.

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Overall, most of the 11 trusts invest in an adventurous rather than a cautious manner. Therefore, it is not surprising to see gearing being utilised.

In contrast, investment trusts with a more defensive approach tend to have low gearing levels or no gearing at all.

Investment trusts upping gearing levels 

*Minimum threshold for inclusion three percentage points. Source: AIC and Morningstar. Debt measured at par. Performance data from FE Fundinfo, to 24 August 2022. Past performance is not a guide to future performance.

Nick Britton, head of intermediary communications at the AIC, makes the point that in stressed market conditions, such as those we saw in the first half of this year, it may seem counter-intuitive to be taking on more borrowing.

Britton adds: “However, in the long term it can make sense to buy assets when they are going cheap. Many investment companies have borrowing arrangements in place similar to an overdraft facility, so they can dip into it when they see attractive opportunities. These decisions can really pay off over the long term as markets recover.

“Open-ended funds, by contrast, are often forced to sell assets near the bottom of the market when their investors decide they have had enough and sell their units in the fund. This leaves them strapped for cash at the very time they might want to be taking advantage of opportunities.”

Gearing explained

Simply put, if the manager borrows X to invest and the trust grows, the manager has to repay X plus interest but retains the investment growth as part of the trust's NAV. So if you have £1,000 invested (let's assume a constant share price for now) and the manager gears by 10%, then there is effectively £1,100 working for you.

Now, if that doubles in value to £2,200, the manager pays back the £100 plus interest, let's say 1%. That leaves you - the investor - with £2,099. If the manager had not geared, you'd have only £2,000.

Conversely, if the same investment halves in value to £550, the manager still has to pay back £101. This magnifies the losses, leaving you with only £449 instead of the £500 you'd have without gearing.