The freedom of investment trusts to gear is one of the important characteristics that differentiates them from other collective investments, such as unit trusts and Oeics.
Gearing has the impact of magnifying the trust's performance and can be simply described as 'borrowing to invest'. This is something that is a common practice in our own financial lives: we borrow money to help us pay for a house (an asset such as shares) and believe that the price of the house will rise and make us more money, over and above the amount borrowed.
Investment trusts can apply the same technique, borrowing to enhance returns from the stock market. Most conventional trusts will have a limit on their ability to gear, typically about 30%.
Gearing works by magnifying the investment trust's performance, so if a trust 'gears up' and then markets rise and performance is good, the return to the investor will be even greater. But if performance is poor, losses will be increased.
The example of buying a house is a good one. If you buy a property for £110,000 and borrow £100,000, you put up £10,000 and borrow 10 times that amount. If the value of the property doubles, then when you sell for £220,000 and repay the £100,000 loan you are left with £120,000, 12 times your original investment, despite the fact that the property only doubled. That is the power of gearing. Of course, this can also work against you as a fall in value of the property of only 10% will wipe out your equity: a 10% fall becomes a 100% loss.
This is why gearing on investment trusts is rarely more than 30%, compared with the example of a house purchase.
Over the long term, markets have usually risen and gearing is a tool investment trust managers have used effectively in the past to generate strong performance and provide income, capital growth or relatively low-risk growth for investors.
Cazenove study
Last year, a study by Cazenove looked at the impact of gearing on the 12 largest conventional investment trust sectors, excluding venture and development capital. The conclusion was that gearing had added 5.3% to investment trust performance over the preceding seven years to the end of December 1999, equivalent to 0.75% a year. Trusts investing in UK large and mid-cap stocks gained an additional 6.5% from gearing over the seven-year period, which allowed them to outperform the FTSE All-Share Index.
Equity market returns have generally exceeded the cost of debt and the current low inflation and low interest rate environment for the UK economy has made borrowing cheap. Gearing also allows investment trusts to take advantage of new opportunities without having to sell their existing investments. In addition, it can increase the income available to investors and provide a way to hedge currency risk.
Most conventional trusts do include some gearing, about 70% of them, according to the Cazenove study. The use of gearing for a conventional trust rests on the judgement of the board and the fund manager. The gearing limits of an investment trust are set down in the memorandum and articles of association and the board usually approves the amount and type of gearing to be used. Tactical gearing decisions, such as when to deploy the gearing that has been authorised, are usually taken by the manager.
At the end of January 2001, conventional investment trust member companies had an average size-weighted gearing ratio of 117%. When looking at gearing ratios it is important to remember that 100% means the investment trust is not geared at all. A gearing ratio of 117% means the investment trust has borrowings equivalent to 17% of the trust's assets. So in an investment trust with assets of £100m, the gearing effectively increases the size of the trust to £117m. This can help reduce the fixed costs per share and make the trust more economical to run.
The gearing ratio varies a great deal between the conventional investment trust sectors. For example, the UK High Income sector is the most highly geared conventional sector with a size-weighted average gearing ratio of 216%. The investment trusts in this sector have borrowings equivalent to 116% of their assets on average.
The second most highly geared sector is Global Growth and Income, with a size-weighted average gearing ratio of 167%.
The Global Emerging markets investment trust sector has the lowest level of gearing, with a size-weighted average ratio of 105%, with the UK Smaller Companies sector at 109% and Global Growth sector at 110%.
There are a number of ways in which investment trusts incorporate gearing. Trusts have traditionally geared by using long-term debentures or preference stock, which will be fixed, long-term liabilities with a fixed redemption date.
Trusts can also gear by arranging bank loans that may be secured against their portfolio of investments.
Fixed-rate bank loans offer greater flexibility as they can be set for a short or long term, whereas variable rate loans or floating rate notes are useful if rates are expected to fall.
Straightforward overdraft facilities can be used for gearing but are usually only suitable for the short-term. Trusts can also gear by issuing more specialised types of securities, such as preference shares or convertibles.
Another way of providing gearing is available through the structure of split capital investment trusts. In these kind of trusts, gearing is provided by the capital structure. Shares that have a fixed entitlement to assets on liquidation provide gearing to the other classes of share. For example, income shareholders take all the income available for distribution but forego increases in capital.
This also allows trusts to offer investors zero dividend preference shares with a reasonably assured rate of return because the value of the total assets covers their repayment entitlement throughout the trust's life. This structure of split capital investment trusts offers the possibility of enhanced returns over different levels of risk, from one portfolio.
Zero dividends
Low-risk investors who want a fixed capital sum in the future will find zero dividend preference shares attractive. Zeros are the first class of share to be paid on the wind-up of a trust after any loan stock. The zeros then also gear up the other classes of shares to give a high yield and possible increased capital entitlement.
The next class of share to be paid on wind-up is the income shareholders. They receive the income throughout the life of the trust and any capital they are owed.
The final class of share to be paid on wind-up is the capital shares. These are suitable for more adventurous capital seekers.
An important step forward for the investment trust industry is the increased use of share buy-backs. This is when the trust's board buys back the shares of the investment trust, reducing the supply. These are well under way and add value to shareholders in two ways: if a trust buys back shares at a discount it increases the underlying value of all remaining shares; and by removing supply from the market, it should also ensure that there is a floor to the discount and thus will firm up share prices.
In 2000, the value of share buy-backs rose to more than £1.6bn but, perhaps more significantly, these were spread across more than 110 funds.
A share buy-back programme will increase the level of gearing because the number of shares is reduced and the two policies have to balance against each other. A rising market will offset the increase in gearing, but in a falling market, where a trust's discount is widening, the board and manager may want to buy back shares but also limit the impact of any gearing on the value of the net assets.
The structural advantages of investment trusts, such as gearing and lower charges, help them deliver where it really counts strong performance over the long-term. The Cazenove study, which shows that gearing had added 5.3% to investment trust performance over the preceding seven years to the end of December 1999, equivalent to 0.75% per annum, is the key proof of this.
Gearing in its many different forms is an important instrument in the armoury of an investment trust and is a key differentiator between investment trusts and open-ended vehicles.
Daniel Godfrey is director general of the Association of Investment Trust Companies