One of the biggest differences between unit trusts and investment trusts is that investment trusts are allowed to borrow money to invest. This ability can be used to produce very high comparative returns, though it also increases the risk profile of the investment for the investor.
When an investment trust is first founded and it sells shares in itself to raise cash, that cash will be used to buy assets and shares in companies. It is the growth of these investments that produces an increasing share price, and the net asset value can be held as collateral when the investment trust borrows money to make further investments.
The mechanism of borrowing money to invest is known as gearing, and by investing borrowed money the investment trust will boost any gains it makes on its original investment. However, if the investment trust does poorly any losses will also be enlarged.
Consider an investment trust that has £100 million under management, and borrows a further £100 million to invest. If the market rises by 50%, then it will have turned its total £200 million into £300 million. When it pays back the £100 million it owes, it will have a net asset value of £200 million – or a 100% gain on the original investment amount before it geared up by borrowing money to invest.
However, if the same fund had borrowed £100 million and invested it before the market fell 50%, instead of rising, the total invested amount of £200 million would now only be worth £100 million. When the investment trust sells enough assets to repay the loan, there would be nothing left for investors – in other words, the geared investment will have caused the investment trust to collapse.
Gearing an investment adds to the capital risk of the investment – proving the saying ‘the greater the risk, the greater the potential reward’, and the higher the gearing the higher the risk.
In reality, a geared investment trust is not likely to fall to zero though not for a particularly good reason. When a bank or other financial institution lends money to an investment trust it is likely to have clauses written into the loan agreement that stipulate repayment must be made if the value of assets falls below a certain level. This could trigger a fire sale, and though the investment trust will likely still have some value it will be hard to recover to previous levels.
When combined with the way in which investment trusts are priced, with the shares trading at discounts or premiums to net asset value, gearing is a key factor why investment trust prices can be volatile (and certainly more volatile than the prices of unit trusts and OEICs).
The amount of borrowing an investment trust has made is commonly expressed as a gearing rating. This rating is based on a level of 100, when a trust has no borrowings and no gearing. A rating of 125 means the fund has gearing of 25% of its total assets: profits or losses would be amplified by 25%.
Is gearing for you?
Understanding the effect of gearing is important in deciding whether a particular investment trust is the right investment. An investor who is looking to invest in a diversified portfolio of shares but getter a potentially higher reward from that investment will be more willing to invest in a highly geared investment trust than one who is looking for a higher level of capital safety.
The actual investment performance of the investment trust managers should also be looked at closely. An investment trust that produces a return of 10% per year with no gearing may be a better investment than one that produces 12% per year with 50% gearing when looking at it from a risk/ reward perspective. An investor should always ask if the gearing is producing a comparable uptick in returns.
Investment trusts can use borrowing facilities to greatly enhance their investment returns, and this could be an important factor for investors. However, it has to be remembered that with increased profit potential comes increased risk. Just as any upside would be magnified when gearing investments, so too is the downside in a falling market.
This said, the low cost of entry and exit on investment trusts (they trade like any other share on the stock exchange) make them attractive to both traders and investors. Traders like them because they allow short term speculation on a wide range of securities in a simple way, while investors use them because not only are they well diversified, professionally managed funds, but the long term investment return is affected less by costs than unit trusts and OEICs.