Gearing refers to the ability to borrow in order to enhance returns, something a manager of an open-ended fund does not have the luxury of doing. This borrowing makes some investors wary, particularly when the effects are still being felt of a financial crash that was fuelled by too much debt in the first place.
However, Winterflood’s Simon Elliott (pictured) explains that most investment trusts use gearing successfully.
"Essentially, gearing is a distinguishing feature of investment trusts and is one of their advantages over open-ended vehicles," Elliott said.
"That is not to say that all investment trusts are geared, but 5 to 10 per cent gearing is usually the norm."
"Gearing allows fund managers to take market views, so they can increase their gearing if they think the market is attractive or reduce it if they feel there is risk to the downside."
"Essentially, if markets rise or the asset class appreciates in value, it will benefit trusts that are geared."
"With equities, over time you would hope that prices go up so obviously gearing is a good strategy in that respect."
"Of course the reverse can be true, because if markets fall then gearing will hurt performance," he added.
The devil is in the detail, of course, and Elliott warns that there are different forms of gearing that managers use.
Some trusts use long-term structural gearing in the form of debentures, effectively bonds that are not backed by collateral, while others use shorter term methods such as bank loans.
Elliott says that investors should not be put off by a trust that is geared, but it is something that they should always keep an eye on, making sure they understand the policy and how closely the manager is following it.
"The general point about gearing is that investors should be aware whether or not an investment trust applies it," he said.
"They also need to look at whether or not the trust has a disclosed maximum level of gearing."
"There have been instances where we have felt trusts have been overly geared. One such trust was Fidelity China Special Situations which, under Anthony Bolton, had gearing of 20 to sometimes 29 per cent of its net assets."
"We felt that was quite high for a trust that invested in mid and small cap Chinese equities, for instance."
The underperformance of Bolton’s Fidelity China Special Situations fund has been well documented and it was recently announced that he will retire in April 2014. Dale Nicholls will take over from him.
According to FE Analytics, the trust has lost 13.05 per cent since its launch in April 2010 while its benchmark – the MSCI China index – is down 3.01 per cent.
Performance of fund vs index since Apr 2010
Source: FE Analytics
As Elliott highlighted, the closed-ended fund had had gearing of close to 30 per cent at certain points over the last three years and although that level has dropped, this level is still at 19 per cent.
Managers who increase or decrease their gearing at the right time have a better chance of outperforming their market and their peers.
Charles Cade, head of research at Numis Securities, says F&C’s Jeremy Tigue is a good example.
He says Tigue is different to certain managers because he does not maximise gearing when markets are on the way up.
"He has a good record of reducing his level of gearing when markets are rising," Cade explained.
"Tigue will reduce his gearing when markets rise if he feels valuations are over-stretched. That means that when there is a set-back in the market, he has cash on the balance sheet to reinvest."
"Some managers do it the other way round, so when markets fall, their gearing goes up and so they are forced to sell, but he has a good record of being able to buy back stocks that have been hit by the market," he added.
Tigue has managed the Foreign & Colonial Investment Trust since 1997. Over 10 years it has returned 171.62 per cent, beating its FTSE All World benchmark by nearly 30 percentage points.
Although the trust lost money in 2011 – a particularly difficult year for equities – it still beat the index.
The trust also beat the index in 2012 and is currently up against it so far this year as equity markets have recovered.
Performance of trust vs index
| Name | 2013 returns (%) | 2012 returns (%) | 2011 returns (%) |
|---|---|---|---|
| Foreign & Colonial Investment Trust | 16.29 | 14.04 | -4.64 |
| FTSE All-World index TR in GB | 15.54 | 12 | -6.57 |
Source: FE Analytics
The trust is currently geared at 12 per cent and has ongoing charges of 0.56 per cent. Foreign & Colonial Investment Trust is trading on a 10.2 per cent discount to its NAV.
Cade also highlights Bruce Stout as a manager who has a proven track record with gearing.
He says Stout has been able to magnify the returns of his Murray International Investment Trust by raising gearing at the bottom of a market dip and then reducing it when markets begin to rise.
One closed-ended fund that is highly geared compared with its peers is FE Alpha Manager Alex Wright’s Fidelity Special Values Trust.
It is currently geared at 21 per cent; however, Cade says this is not a reason to avoid the trust.
"It isn’t something to be concerned about," Cade said. "The trust has been performing well under Alex Wright and if he is positive on the current environment, then it is encouraging that he is using that level of gearing."
Wright took over the closed-ended fund from Sanjeev Shah in September last year.
Performance of trust vs index since Sep 2012
Source: FE Analytics
It has returned 51.97 per cent since then, while its benchmark – the FTSE All Share – is up 16 per cent.
The trust has ongoing charges of 1.24 per cent and is still trading on a 7.9 per cent discount to its NAV.
