‘Gearing’, ‘borrowing’ and ‘leverage’ are dirty words right now with the row raging between banks on one hand that have the money to lend being criticised for holding onto it, with customers on the other who seemingly are unwilling to borrow.
With companies of all sizes being over-leveraged going into 2007/2008 investors are still wary of paying too much credence to a firm that has a large amount of borrowed capital on its balance sheet.
Yet the ability of investment trusts to borrow is one factor that distinguishes closed-ended vehicles from their open-ended equivalents, and when designing portfolios a geared position can be a positive.
Some trusts are structurally geared, with property being an obvious example – the European, UK and Asia Pacific sectors are geared up by 169%, 170% and 126% respectively – so this should not come as a surprise to anybody.
There are others that saw gearing as a disadvantage going into 2007/2008 but then used it to dig themselves out of the exact same hole.
Scottish Mortgage Investment Trust, for example, is one that got beaten up in the crisis, with its NAV halving in October 2008 alone. Its annual share price performance between June 2007 and 2008 (its own financial year) was 5.9% while for the following year, to the end of June 2009, it registered a loss of 34.7% ; in the 12 months to the end of the following year it was back up by 44.4%.
Another example that gives a more direct comparison with its open-ended counterpart is that of the Schroder UK Growth trust that, since 2006, has been managed in line with the Schroder UK Alpha Plus unit trust.
Earlier this year, Alan Brierley, Canaccord Genuity’s investment trust analyst, commented: “The investment trust has had a chequered past but after a near-capitulation phase during 2008, the performance has since improved materially; the NAV total return of UK Growth is some 7.5% ahead of UK Alpha Plus since the beginning of 2009.”
Adding gearing does not necessarily mean adding risk as the very concept of gearing is a competitive advantage as long as, logically, the cost of borrowing is exceeded by the returns. Trying to out-perform cash means that a manager has to inherently take on an element of risk so what has to be looked at closely is the controls around the trust’s borrowing.
Irrespective of the product structure, risk control is paramount and minimising losses in preference to maximising returns is the trade-off.
Gearing is an important part of the make-up of investment trusts and borrowing levels have remained stable at 7% or 8% according to the Association of Investment Companies over the past few years.
Markets have been tough for those that have borrowed in the past few years, but long-term investors should not be put off simply because investment trusts are or are not geared/leveraged/borrowing.
