Investment trusts are missing a trick by failing to tactically use gearing to aid performance, according to analysts at Winterflood.
The broker said in a report that persistently low interest rates implied more flexible trusts should consider leveraging their portfolios in a bid to boost returns.
Analysts Simon Elliott, Kieran Drake, Innes Urquhart and Emma Bird said trusts’ use of gearing tended to be strategic rather than tactical. They predicted companies burdened with expensive debt might find it too risky to use new debt tactically, but said others with cheaper debt could benefit.
The trio said: “For funds with cheaper debt it may be more reasonable for them to use their gearing tactically, and we wonder whether an opportunity is being missed. For funds which still have expensive long-term debt in place, where interest costs are high, out of market risk may be considered too high a risk to take.”
The use of gearing is a differentiator for investment trusts compared with their open-ended peers. It lets investment managers enhance returns, albeit at the risk of volatile performance.
Trusts often use longer-dated debt to strengthen performance over a market cycle, on the basis that additional investment returns would outstrip the cost of borrowing. They can also take our short-term loans to enhance returns opportunistically.
Ewan Lovett-Turner, director of investment company research at Numis, said it made sense for trusts to use gearing flexibly rather than on a long-term basis.
He said: “The approach to gearing does vary considerably by fund. In general we believe that it is preferable for managers to use gearing on a flexible, opportunistic basis, rather than for a fund to be saddled with structural gearing throughout the market cycle.”
Mr Lovett-Turner noted that some trusts were constrained by long-term and expensive debt. Four UK equity trusts have 15-year debt with an interest rate of more than 4 per cent, and 10 have debt with maturities of 20 years or more at more than 3 per cent. A 30-year UK gilt has an interest rate of 1.5 per cent.
Others were not so sanguine. Effective use of tactical gearing does require managers to time markets, rival analysts warned.
Cantor Fitzgerald director of investment company research Monica Tepes said it was impossible to say whether tactical gearing was ever successful, given the lack of evidence.
She said: “Trusts don’t normally split out the impact of gearing and even if they do, there is still the question of how its impact may compare with that of having structural gearing in place. Also tactical gearing is relying on being able to time the market correctly. That is not easy even at an unlevered level.”
Charles Murphy of Panmure Gordon said he could not provide an example of a successful attempt to implement tactical gearing. “I would be very wary of selected reporting on this type of investment strategy,” he said.
Mr Lovett-Turner said Alex Wright, manager of the £626m Fidelity Special Values trust, was one such manager. The fund currently has no leverage, but gearing stood at double-digit levels following the market slump at the beginning of last year, indicating a valid opportunistic use of borrowing powers. A counter-argument is that the fund has underperformed its benchmark since the beginning of 2016.
