Investment trust gearing levels were ‘modest’ heading into market sell-off

Data shows that ahead of the sell-off most investment trusts had ‘modest’ gearing levels, so losses were not as heavy as they otherwise could have been.

The use of gearing to enhance returns over the long term is a key advantage for investment trusts, providing the trust’s underlying investments increase in value. But when markets fall heavily, gearing has the reverse effect: investors will suffer greater losses per share.

The good news, though, according to data from Winterflood and the Association of Investment Companies, is that heading into the sell-off, most investment trusts had “modest” gearing levels, with various managers adopting a relatively cautious approach.

This chimes with research carried out by Money Observer last November, which found that on the whole investment trust managers had been reducing gearing levels. Data provided by Morningstar found that almost 100 equity-focused investment trusts had reduced their gearing over the year from September 2018 to September 2019.

The data published by Winterflood shows that at the end of January the median level of gearing out of 183 trusts sampled was 5% of net assets, which the broker describes as being “relatively modest”. 

Winterflood notes: “While gearing is sometimes cited as a reason to avoid investment trusts, we would contend that its use is sensibly applied on the whole and is one of the reasons for the sector’s long-term outperformance.”

Following the steep market sell-off, the data shows that 39 trusts (21% of the sample) decreased gearing. In addition, the number of ungeared trusts increased from 64 (35%) to 70 (38%).

Winterflood points out that while it can be assumed that the decision to de-gear is a conscious one, the same is not true necessarily of an increase in gearing, as this could simply reflect a fall in net assets.

Even before Covid-19 became a serious problem, there were many investors who felt that the bull market was running out of steam, notes James Carthew, head of investment company research at QuotedData.

He adds: “Or looking at it another way, I would be hard-pushed to name many managers who thought their stocks were very cheap.

“There are some funds that have gearing built into their structure – the split capital funds, for instance. They suffered very badly when the market dived (Acorn Income, Aberforth Split Level, for example). There are a couple of funds we follow that always run with high gearing but use that to buy bonds or preference shares, which tend to be more resilient when markets fall. They (Henderson High Income, Shires Income) held up pretty well.”

Star fund manager Nick Train, manager of the Finsbury Growth & Income trust, is adopting a cautious approach in relation to gearing levels. In a recent update, he told investors the trust remains fully invested, “but with very modest gearing, currently 1.1%”.

He added: “We have no appetite to take extra risk with the balance sheet. But being fully invested means the portfolio will participate in any eventual rally and recovery. A lesson from previous episodes of stock market panic is that it is impossible to identify the bottom and almost as difficult to get money invested after the market has turned – because prices rally so quickly. Although whether this panic will play out like previous ones is unknowable.”

What is gearing?

Investment trusts are allowed to gear, or borrow to invest. This can improve their performance, but it means they tend to be more volatile than their open-ended peers. Gearing in a rising market magnifies gains for each shareholder; but if the market falls, investors in a geared trust will suffer greater losses per share.

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 net asset value. 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, let’s say, 1% interest. That leaves you – the investor – with £2,099. If the manager had not geared, you would 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 would have without gearing.