Simply put, gearing refers to the practice of borrowing money to invest. Among investment trusts, it's a strategy used to potentially enhance returns for shareholders but comes with an increased level of risk. This article explores the intricacies of gearing within investment trusts, highlighting how it works, its potential benefits and the risks involved.
HOW GEARING WORKS IN INVESTMENT TRUSTS
Investment trusts, which are closed-ended investment vehicles listed on stock exchanges, can borrow money to invest in additional assets. This borrowed money is used to buy more investments in the hope that these investments will earn more than the cost of borrowing. The term ‘gearing’ originates from the idea that borrowing acts like a gear in a machine, amplifying the output (in this case, investment returns) from a given input (the original investment).
When an investment trust is said to be ‘geared’, it means that the trust's manager has taken out loans to invest more capital than the trust initially had from its shareholders. The level of gearing is often expressed as a percentage, indicating the ratio of borrowed funds to shareholders' equity.
THE BENEFITS OF GEARING
The primary benefit of gearing in an investment trust is the potential for enhanced returns. If the investments made with borrowed funds perform well, the returns can significantly exceed the cost of borrowing, leading to higher profits for shareholders. This leveraging effect can make investment trusts more attractive to investors seeking higher returns, especially in bullish markets where the prospects of outperforming the borrowing costs are favourable.
THE RISKS OF GEARING
While the benefits of gearing can be substantial, the risks are equally significant. Gearing amplifies losses just as it does gains. If the investments made with borrowed money decline in value, the losses incurred can exceed the initial investment, leading to a magnified negative impact on the trust's net asset value (NAV). Additionally, investment trusts with high levels of gearing may be more vulnerable to market volatility and interest rate increases, as the cost of borrowing can rise, squeezing the profit margins from geared investments.
MANAGING THE RISKS
Investment trust managers employ various strategies to manage the risks associated with gearing. These include careful selection of investments, maintaining a diversified portfolio to spread risk and closely monitoring market conditions to adjust the level of gearing as necessary. Some trusts set a gearing limit to ensure that borrowing does not exceed a certain percentage of the trust's assets, providing a buffer against market downturns.
IS GEARING RIGHT FOR YOU?
Whether gearing in an investment trust is suitable for an investor depends on their risk tolerance, investment horizon and financial goals. Investors comfortable with higher levels of risk and seeking greater returns may find geared investment trusts appealing. However, it's essential for investors to understand that gearing can lead to increased volatility and potential losses. Thorough research and a clear understanding of an investment trust's gearing policy and risk management strategies are crucial before making an investment decision.
This Trustnet Learn article was written with assistance from artificial intelligence (AI). For more information, please visit our AI Statement.