The sign that some UK trusts are turning more bullish

Some investment trust managers are taking advantage of one of the sector’s unique selling points.

A number of UK equity investment trusts are taking an increasingly optimistic stance towards the market they invest in by upping gearing levels.

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 (see below for a more detailed explanation).

Data from Winterflood shows that from 5 August 2020 to 5 February 2021, there are various examples of UK fund managers seeking to capitalise from the ‘cheap’ UK market. At the latter end of this six-month period, one of the big headwinds casting a large shadow over the UK market was removed – the risk of a no-deal Brexit.

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Fidelity Special Values (LSE:FSV), which is managed by contrarian investor Alex Wright, has notably upped gearing levels over this period, from 10% to 17%. Of late, Wright has been significantly increasing exposure to specialist retailers, such as Halfords (LSE:HFD) and Dixons (LSE:DC.), as well as car distributors, DIY stocks and housebuilders.

He says: “Both UK equities and value stocks have been out of favour for a prolonged period and their share prices have proved particularly susceptible to the pandemic. While it has proved a challenging backdrop for value investors, this has resulted in an unusually broad choice of attractively valued stocks with good upside potential, including companies whose earnings are already exceeding expectations.”

Invesco Perpetual Select UK Equity (LSE:IVPU) and Temple Bar (LSE:TMPL) have also been strategically increasing gearing levels. Over the six-month period, the Invesco-managed trust upped gearing from 12% to 19%, while Temple Bar has increased gearing from 6% to 15%.

In early November, Temple Bar swapped fund management groups, ditching Ninety One (formerly called Investec) in favour of RWC Asset Management. Like previous fund manager Alastair Mundy, who stepped down early last year for health reasons, the new fund managers - Nick Purves and Ian Lance-  are also value investors.

Other examples of UK-focused trusts that have been increasing gearing are Invesco Income Growth (LSE:IVI), from 3% to 7%, and Murray Income (LSE:MUT), from 6% to 10%.

Other UK trusts have kept gearing levels broadly the same over the six-month period, while some do not gear, such as Troy Income & Growth (LSE:TIGT).

Two trusts, though, that have been notably reducing gearing are Law Debenture (LSE:LWDB), from 19% to 12%, and Merchants (LSE:MRCH), from 18% to 14%.

In the smaller company space Henderson Smaller Companies (LSE:HSL), one of interactive investor’s Super 60 choices, makes use of gearing, which is currently 10%.

In the trust’s half-yearly results, which were published at the end of last month, manager Neil Hermon was upbeat about the outlook for the UK market.

He commented: “Although much uncertainty remains around short-term economic conditions, the virus will pass and we should see a recovery. The movements in equity markets have thrown up some fantastic buying opportunities and we expect many listed companies to emerge stronger from the downturn. However, it is important to be selective as any recovery will be uneven and strength of franchise, market positioning and balance sheet will determine the winners from the losers in a post Covid-19 world.”

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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.