Should investors stop fearing gearing?

“The advantage of leverage is that equities should outperform other asset classes, especially with companies with progressive dividend policies,” says Stephen Peters, investment trust analyst at Charles Stanley.

“So if you can invest in a portfolio of companies that is yielding you 4 per cent and your cost of borrowing is say 2 per cent, you are making money by using that leverage. The risk is that the value of your assets declines while the cost of your debt remains the same.”

In a falling environment there is of course potential for leverage to exaggerate losses for investors, acknowledges Simon Moore, senior research analyst at Bestinvest, but the manager has tools to reduce risk on a downturn, such as by holding cash or bonds.

He adds that as well as potential volatility, gearing is another potentially puzzling piece of information that investors need to consider before investing.

But he suggests homeowners should easily understand the concept – and that mortgages are a good example for explaining leverage to any client.

“A typical retail investor has a mortgage on his home... his ‘equity investment’ may only be as little as 10 per cent of the property value. If his home goes up in value his return is amplified by the effect of gearing,” he says.

“Several generations of particularly south-east homeowners have made their personal fortunes in this way.”

Annabel Brodie-Smith, communications director at the AIC, questions whether gearing does actually put off clients, since investment trusts have been favoured by many self-directed private investors.

“It is the level of gearing for a potential investment that is the issue,” she says. “Many investment trusts have no gearing, others have gearing only to very modest levels and the average gearing level is just 7 per cent.

“Very high levels of gearing tend to be prevalent amongst a relative small number of specialist companies and sectors.”

She suggests advisers need to choose sectors and companies with a gearing level that is appropriate for their clients’ risk profile.

Gearing information is easy to obtain on the AIC’s website, where, following adviser feedback, gearing is now published as a percentage figure.

At the request of advisers, who want to understand whether figure lie within a company’s normal range, the AIC is also looking to publish the minimum and maximum levels of gearing over the past three years.

It is now recommending that IT boards publish a gearing range to demonstrate what the board’s view of the company’s range of gearing in normal market conditions is.