The dramatic expansion in the buy-to-let property market shows the willingness of people to borrow money to invest. Likewise, the ability of investment trusts to borrow money is one of the characteristics that separates them from open-ended funds and will therefore appeal to many investors.

Borrowing money to make further investments is known as ‘gearing’. If markets or stocks rise in value by more than the cost of the loan, the investment trust can repay the loan and retain the profit. In rising markets, therefore, geared investment trusts can outperform those that are not geared.

For example, if you have a portfolio worth £100,000 and the underlying investments rise ten per cent, it is worth £110,00. If the same portfolio had borrowed £30,000 then it would be worth £113,000 minus the cost of the loan.

Gearing, however, also increases the risk inherent in investment trusts. If markets, or stocks, move against the trust, it will suffer through losses as
well as the cost of the loan.

The use of gearing will vary according to stock market conditions and the number of investment opportunities identified by fund managers. According to the Association of Investment Companies (AIC), the weighted average gearing in the UK growth sector, for example, was 110 per cent on 31 January 2008 compared to 125 per cent on 31 January 2003, near the bottom of the bear market.

How to gear
There are a number of ways in which trusts can gear. A traditional method was to use debentures, which may have a life of 20, 25 or 30 years. Debentures pay a fixed rate of interest and have a fixed repayment value.

If a trust is wound up, debenture holders take precedence over preference shareholders and ordinary shareholders.

Witan Investment Trust, for example, has two debentures, with the last one maturing in 2020. Its debentures pay eight per cent and six per cent a year. James Budden, marketing director of Witan Investment Trust, says the advantage of debentures is that trusts always have access to capital.

However, Budden admits Witan is unlikely to use any more debentures and has even investigated paying back its current debentures. ‘Given the cost, it would not be in the interests of shareholders to pay back the loans early.’

One of the reasons why debentures have fallen out of fashion is their long-term fixed rate of interest. One trust is reputed to have a debenture paying 12.5 per cent a year. With interest rates now at 5.25 per cent, this rate of interest looks expensive. Equity returns and dividends are likely to fall along with the rate of interest, making it harder
to outperform the cost of the loan.

There may be periods when trusts cannot find investment opportunities. Trusts with debentures may put the borrowed capital into cash or even bonds during these periods. But cash deposits are unlikely to outperform the cost of the loan.

Going to the bank
An alternative is to use bank loans. Some trusts have used long-term borrowing from banks but they face the same challenges as debentures if interest rates fall. Trusts, however, may decide to issue debentures or use long-term bank borrowing if they believe interest rates will rise. The trusts will benefit from a relatively lower cost of capital as equity returns and dividends are likely to increase.

Structural long-term borrowing is also common among property trusts because of the nature of the underlying investments, according to Nick Greenwood, head of investment trusts at iimia.

It is now more common for trusts to use short-term borrowing from banks, which gives managers more flexibility. James de Sausmarez, head of investment trusts at Hendersons, says trusts typically borrow up to 20 or 30 per cent of their assets. It is uncertain whether trusts will continue to find it as easy to borrow money as the credit crunch bites and banks raise the cost of capital.

The risk of a bank loan is that it might be called in. An example of when a loan might be called in is if the original loan was £25 million and the trust had assets of £100 million, but this value fell to £60 million. The bank may feel the value of the collateral has fallen too close to the value of the loan.

De Sausmarez says the rate of interest is usually slightly over Libor. ‘Therefore,’ he says, ‘gearing is not a costly exercise.’

When to apply the gearing
So when should fund managers ‘gear up’ their portfolios? Greenwood says
he gears when he finds more buy than sell ideas, because this means he does not have to dispose of any holdings.

He is, however, cautious about boards of directors taking decisions on gearing. ‘Like private clients, some boards gear at the top of the market and de-gear at the bottom of the market,’ comments Greenwood.

Tom Walker, manager of Martin Currie Portfolio Investment Trust, says the trust usually approaches three or four banks to get the most advantageous rate. It has also geared in multiple currencies. Walker says the trust has borrowed in dollars and yen to hedge
its currency risk. Such borrowing can enhance returns, as well as losses, from movements in currencies.

Walker points out that trusts now often use short-term borrowing from banks, such as for three months or a year. Alternatively, trusts can arrange an overdraft facility with a bank. Walker explains, ‘We can arrange to access £10 million or £20 million and there is no charge until we withdraw the money. Once the money is withdrawn, this may be lent for three months at a rate slightly above Libor.’

Greenwood says the iimia Investment Trust also uses such a facility: ‘We can draw on this facility whenever we want to gear. It is completely flexible so we can pay back the loan whenever we want.’

Another way of enhancing the exposure of a trust is through derivatives. Hugh Aldous, chairman of the Eastern European Trust and a member of the Henderson PR Pacific Trust board, says there has been a significant increase in the use of derivatives over the past few years.

This may be to de-gear a portfolio as well as to gear. He explains, ‘Derivatives are
used to gain exposure to investments without having the capital, to take a short position or hedge a particular exposure.’ Shorting can enable a trust to profit if a market or stock
falls in value. The decision to use a bank loan or derivatives for gearing depends on the circumstances. ‘If a manager is bullish about a particular asset class or market, like Russia, he or she would be likely to take out a bank loan,’ says Aldous.

He adds, ‘This is often a tactical allocation. But if a manager is concerned about the short-term outlook for some stocks or a sector, they might use derivatives to hedge the position because they don’t want to sell out of the position.’

A matter of tactics
Walker says that in using gearing, ‘We take tactical top-down views of markets. If we are bullish about the outlook for markets, then we gear to top-up existing stocks in the portfolio. In our view, they are the best stocks so why would we invest in any others? Topping up these stocks is the optimum way for us to gain enhanced exposure to a market.’

Fund managers can also de-gear a trust by increasing its exposure to cash. Aldous points to the fact that in 2001 Mark Mobius increased exposure to cash to 40 per cent of the Templeton Emerging Markets Trust. ‘At the AGM, investors asked why he was not fully invested. Mobius said it was because he could not find enough value stocks. He was proved right.’

Split capital investment trusts have long-term gearing through the use of zero-dividend preference shares. Investors in zeros are given a fixed return when the trust is wound up, such as eight per cent a year, and have first rights over the assets. The shares cannot be called-in, unlike a bank loan. The risk for investors is that there are insufficient assets in the trust to provide the promised return.

The board’s view
Despite Greenwood’s concerns, Aldous says the board of directors should have a view of the risks and rewards of gearing by their fund manager. He notes, ‘The directors have to understand the manager’s investment style and ability to call the market. They have to decide if a manager has the necessary skill to use shorting and derivatives. The gearing policy should also be communicated to investors.’

Aldous adds, ‘There should be constant dialogue between the manager and the board over the level of gearing by the trust. An important consideration is measuring performance and the question of paying performance fees. The board has to decide whether outperformance has been derived from gearing a rising index or from stock selection.’

De Sausmarez says a board of directors might agree to gearing of up to 20 per cent of a trust’s assets, for example, and within this the manager has the discretion on how they gear. If the manager wants to go above the 20 per cent limit, they have to get the board’s prior approval.

Walker adds, ‘We have to get board approval if we increase our gearing by five per cent above the previous allowed limit. We have no gearing at the moment so I have to get permission before raising it to six per cent. I can seek permission at the meetings that take place every other month but if I want to gear quickly I can phone the chairman.’