Six in 10 trusts gear up ahead of EU vote

Investment trust managers are sticking to their guns by maintaining gearing levels ahead of the European Union (EU) referendum vote on 23 June.

Uncertainty over the outcome of the vote has led retail investors to adopt a more cautious stance, evidenced by latest industry statistics from the Investment Association (IA), which found that £635 million was pulled from equity funds in April.

Instead, investors have either moved to cash or chosen to favour funds that aim to protect capital in periods of volatility.

But investment trust managers have not been taking risk off the table. According to analysis by broker Winterflood, the average net gearing of all the 179 equity-focused investment trusts is virtually the same as it was a year ago. At the end of April average gearing levels stood at 6.8%, compared to 6.7% year-on-year.

Missed opportunity

Of the 179 equity trusts, a total of 104 were making use of gearing, which works out at 58%. Winterflood adds that despite testing market conditions this year, this is broadly comparable to the position 12 months ago: 113 out of 178.

On a sector level, amongst funds investing in UK equities the average fund's gearing level in the UK all companies sector fell from 7% to 5% over the past 12 months.

But for the UK equity income sector gearing levels increased, from 9% to 11%.

Dunedin Income Growth boosted gearing the most over the last 12 months, moving from 7% to 15%. Three other trusts that have ramped up their gearing levels are City of London, Edinburgh Investment Trust and Merchants.

Simon Elliott, analyst at Winterflood, is surprised investment trusts are not taking the opportunity to reduce gearing levels ahead of the EU referendum vote, which, if the opinion polls are anything to go by, looks too close to call.

"In our opinion strategic gearing is particularly attractive for funds that still have expensive long-term debt," says Elliott.

"However, for those with cheaper, shorter-term debt it may be more reasonable to use their gearing tactically, and we wonder whether an opportunity is being missed.

"Given the levels of gearing currently in place for UK funds, we can deduce that either: managers could be more flexible in their tactical gearing, bearing in mind the uncertainty associated with the forthcoming EU referendum, or they are confident that the result will be to remain in the EU."

What is gearing?

Investment trusts are allowed to gear, or borrow, to invest. This can improve their performance, but it means they tend to be more volatile than their open-ended peers.

Gearing in a rising market magnifies gains for each shareholder; but if the market falls, investors in a geared trust will suffer greater losses per share.

Simply put, if the manager borrows X to invest and the trust grows, the manager has to repay X plus interest, but retains the investment growth as part of the trust's Net Asset Value.

So if you have £1,000 invested (let's assume a constant share price for now) and the manager gears by 10%, then there is effectively £1,100 working for you.

Now, if that doubles in value to £2,200, the manager pays back the £100 plus, let's say, 1% interest. That leaves you - the investor - with £2,099. If the manager had not geared, you'd only have £2,000.

Conversely, if the same geared investment halves in value to £550, the manager still has to pay back £101. This magnifies the losses, leaving you with only £449 instead of the £500 you'd have without gearing.

This article was originally published by our sister magazineMoney Observer here.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.