Investment Trusts: To be, or not to be (geared), that is the question
This is not substantive investment research or a research recommendation, as it does not constitute substantive research or analysis. This material should be considered as general market commentary.
Gearing is part of the toolkit that trusts use to outperform OEICs. But how is it best implemented?…
Investment trusts, compared to open-ended funds, have the ability to borrow and potentially enhance returns through leverage. Of course, this adds to risks.
But over the long term gearing should enhance returns, as long as the cost of gearing remains lower than the returns the manager is able to achieve from investing.
Investment trusts have been employing gearing for many years. Some use fixed rate borrowing, others more flexible borrowing. Scottish Mortgage (SMT) encapsulates the changing nature of fixed rate gearing.
The trust still has some relatively expensive debentures, which mature in 2026, and which pay interest at an effective rate of 10.8%! At the same time, the trust has also issued loan notes repayable in 2048 which bear an effective interest rate of 2.96%.
Both are what we call structural gearing. The advantage of fixed rate borrowing is that the interest rate will remain the same over time, and the loan cannot be called back by the lender – unless the trust breaks any of the covenants.
The two main disadvantages are that the interest rate might end up looking expensive over time, and that investments made may not cover the cost of the borrowing.
Other trusts (such as BlackRock World Mining or European Opportunities) have employed gearing as a core part of their strategy over the long term, but do it flexibly through what is known as a revolving credit facility. This mechanism is effectively like an overdraft, which has a short-term repayment profile and a floating interest rate.
The advantage is that it is very flexible and generally low cost. But if interest rates rise, the interest cost will also rise. In addition the lender might not renew the lending facility, potentially at the bottom of a cycle.
This scenario might mean shareholders suffer from the negative effects of gearing in a down market, but potentially are not able to benefit in the subsequent rebound.
Managers employing both types of gearing can vary their gearing over the short term, by holding cash against any borrowings to effectively de-gear.
This strategy results in lower net gearing – i.e. gross gearing, less cash. However, over long periods, holding cash against fixed rate loans might not be optimal; following the modified Shakespearean adage of “neither a borrower and a lender be”.
As such, those who employ long-term fixed rate gearing do so with the expectation that gearing will be, largely, always on. Those who look to employ gearing tactically tend to use flexible, floating rate gearing. Both approaches arguably suit different investment strategies.
Gearing undeniably increases risks for investors. Firstly, having an exposure to the stock market of greater than 100% means that any investment losses during down periods will be exacerbated.
If an investor needs their capital at that time, then having exposure to a geared trust will have been a poor decision. Gearing also adds to the volatility of an investment, which many investors see as an unattractive feature.
Nonetheless, for long-term investors who are willing to stomach the ups and downs, gearing – especially with interest rates as low as they are today – should enhance any positive returns from stock markets.
Historically equities have delivered good returns over the long term and so, over similarly long timeframes, we believe it makes sense to use gearing to boost returns.
Adopting structural gearing means that investors can potentially benefit from these good long-term returns, and not suffer any mistakes the manager might make in trying to time the market.
As Terry Smith discussed in a recent FT article, market timing is a very hard activity to engage in profitably (read the full article here).
The example Terry gives in the article shows that even if market timing is employed perfectly, the extra returns generated over the long term are not large enough to make it worth the time, energy and risk of getting it wrong.
Structural gearing essentially accepts the extra volatility that will be displayed by equities, in return for extra returns on top of those already generated by the market and by the manager’s stock picking (a.k.a. alpha).
For long-term investors, and for managers who employ a growth (or perhaps less valuation-aware) investment strategy, structural gearing makes absolute sense in this author’s view.
Aside from Scottish Mortgage, which we refer to above, there are many examples of equity trusts which employ structural gearing.
Structural gearing (by our definition) includes trusts with the intent of being consistently geared, rather than being the method by which they achieve their gearing.
An example of this is CC Japan Income & Growth (CCJI), which has an investment policy to have gearing at 120%. It achieves this through CFDs, and uses the leverage primarily to boost income yields.
This approach helps it pay a high dividend yield of 3.7%, which remains the highest in the sector. The managers see the gearing as enabling them to invest and generate a premium level of yield without being forced into stocks which provide good yields but little prospects of growth or growth in income.
The policy to maintain this level of gearing structurally has undoubtedly caused difficulties on the downside when markets fall. But the NAV performance has typically been broadly in line with wider market falls during market corrections since launch, as the stock selection process tends to emphasise defensive characteristics, as we discussed in our recent research note.
Unfortunately this did not materialise in the drawdown in Q1 2020, in our view largely because stock correlations were very high. Yet, as we detail in our recent note, the track record of the trust since inception suggests that, in boosting total returns through higher dividends and increased upside participation, structural gearing does not necessarily entail significant additional downside risk in normal market conditions.
Aberforth Split Level Income (ASIT) uses another form of structural gearing – zero dividend preference shares (ZDPs). ASIT is structurally geared through ZDPs, which receive no dividend and will receive a fixed repayment on 1 July 2024 when the trust is wound up.
The ordinary shares, therefore, retain a higher proportion of income generated than they would through traditional gearing, where they are required to pay annual interest. A major advantage of ZDPs for ordinary shareholders is that they don’t carry the covenants typically associated with fixed debt.
However the fixed entitlement does impact future returns, if the portfolio grows by a lower rate than the ZDPs’ annualised return (4.5% p.a.).
Because of falls in the value of the portfolio this year, net gearing on ASIT’s ordinary shares is now relatively high at 52.1% of NAV (as at 30/06/2020). In the note we published recently, we anticipate a dividend cut on the ordinary shares this or next year, but believe the shares should continue to offer a significant yield premium to the market.
Shorter-term gearing, employed tactically, means a trust can take advantage of gearing without some of the long-term costs and risks of employing structural gearing.
That said there are risks to this approach too, as managers are certainly not infallible in terms of their ability to time markets. In our view tactical gearing is best employed by managers who have a valuation-driven investment process to pick stocks – by which we don’t necessarily mean a ‘value’ strategy.
Many managers have added value over the cycle, by drawing their horns in and de-gearing at times when they find fewer interesting stocks at attractive valuations; and conversely increasing gearing when they find that there are plenty of ideas at undemanding valuations.
Using this method, over time managers should be able to add to positive returns when markets are rising, but hopefully not participate as much when markets are falling.
Trusts which have successfully employed flexible gearing in this way include Henderson EuroTrust (HNE). HNE employs gearing dependent on opportunities presented by stock ideas, or by overall levels of valuations in the portfolio. Manager Jamie Ross manages a watchlist of investments alongside the current portfolio.
Since running a concentrated portfolio requires focus and discipline, he usually applies a ‘one in, one out’ rule when investing in new ideas. If he can’t find a stock he wants to sell, however, then he will use gearing to add to the new holding.
Alternatively, if the overall level of valuations in the portfolio is looking attractive, then he might decide to add exposure across the portfolio by drawing down on the gearing facility.
This latter approach is well illustrated by gearing levels since the summer of 2018. In August 2018 Jamie observed that the market had been performing strongly, but saw relatively few interesting new ideas at valuations he regarded as attractive.
As a result HNE wasn’t employing any gearing at that time. But after the market falls in Q4 of 2018, Jamie reintroduced gearing in early 2019. More recently, according to data from Morningstar, gearing reached a peak in March 2020 just in excess of 10%, and has been reducing again as the market has bounced back.
This flexible use of gearing will undoubtedly have contributed positively to performance, and HNE has been amongst the best performers in the peer group YTD. Gearing currently sits at approximately 2% (as at 30/06/2020).
Dunedin Income Growth (DIG) also provides a good example of tactical gearing being employed to good effect. In fact DIG represents a hybrid approach, using some long-term and low-cost structural gearing, with the additional flexibility to employ flexible gearing on top of this.
Although, generally speaking, the managers are reluctant to apply tactical gearing unless they deem there to be particularly compelling opportunities to do so, the recent market sell-off provided just such an opportunity to increase exposure to high-quality names,which they believed to have seen unwarranted reductions in their share price relative to their ongoing prospects and operational performance.
As a result, through tactical gearing and stock selection, DIG has outperformed peers and the benchmark by over 10% over the past 12 months.
To summarise, we believe gearing is a unique feature that investment trusts have in their toolkit, and they should use it. However the style in which trusts employ gearing should ideally match the style in which managers invest.
As we have discussed, we believe managers who are more valuation-agnostic might be best suited to structural gearing. On the other hand, managers who invest with strong price discipline, in both buying and selling, might suit a more tactical use of gearing.
As with everything, there are no hard and fast rules on what works best. Some trusts, such as DIG, might get the best of both worlds by employing a hybrid approach.
Overall, however, investment trusts suit long-term investors and have historically outperformed open-ended funds through a variety of different means. Gearing is one of them.
And we believe that at the margin trusts should embrace this advantage for their investors, to help them outperform over the long term. After all, nothing will come of nothing.
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