Investment trusts: Knowing your gearing limit

The AIC felt the gearing issue was more complicated than it needed to be and came up with a ‘gearing range’, which indicates a company’s expected maximum and minimum levels

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Back in October last year, the AIC made a number of recommendations to its members on how they might disclose gearing.

The ability to magnify returns through the use of gearing is one of the key advantages of the closed-ended structure   However, the AIC had felt for a while that the sector was making the issue more complicated for investors and their advisers than it needed to be, partly through inconsistencies in how it was being calculated and presented.

So we started by recommending a single, primary measure of gearing, based on the level of gearing compared to the company’s net assets, expressed as a percentage. This may not sound particularly radical, but we faced a situation where some investment companies were disclosing 20 per cent gearing as 120 per cent.  You can imagine the potential for confusion from someone looking at a figure six times bigger than another, and yet being expected to understand that it was expressing the same thing.  Others were disclosing it as a ratio, or basing it on gross assets etc.

One of the advantages of using this gearing percentage is that it has helped to reassure advisers over the impact of gearing.  For example, in our training sessions on gearing, we ask advisers to say what they might see as a significant, short-term fall in an investment company’s assets.  Most usually say between 20 to 30 per cent.  If you know that the investment company is 20 per cent geared (which is quite a high level of gearing compared with the sector average of 8 per cent), then it is quite easy to work out that the gearing would theoretically translate this into a 24 per cent or 36 per cent fall in the net assets.  Advisers new to gearing have often been surprised to see that the impact is not as dramatic as they intuitively felt it would be.

We also asked our members to produce historic gearing figures, showing the highest and lowest levels of gearing used over the past three or five years.  Gearing, of course, rises and falls as markets move up and down, which is not within the control of the directors, but they can take measures to neutralise it (for example by holding cash balances etc).  Historic gearing helps to build a picture of how the company manages its gearing position.

However, even with this information, something was missing. Advisers were concerned that they might recommend an investment company for a client with a modest level of gearing but wake up the next morning to find that the company had suddenly being geared to an unacceptably high level.

Although investment companies, under the listing rules, have to set out their maximum level of gearing, these are regulatory rules which cannot be breached at any time.  Given that gearing rises automatically as markets fall, and thinking about the type of markets we saw during the financial crisis, it is not surprising that some of these limits have been set much higher than a company might ever realistically allow gearing to rise (for example 100 per cent).

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This created a problem. As one adviser said to me: “If I see that a company has set a maximum level of gearing at 100 per cent, I have to assume that this means that the company might one day find itself 100 per cent geared and 100 per cent geared is far too high for any of my clients”. So the company (which is, in fact, very cautiously managed in respect of gearing) was no longer an option for his clients.

The solution we came up with is a ‘gearing range’ which is an indication of the maximum and minimum levels a company would expect to be geared in normal market conditions.

How does this help?  Well, suppose an investment company’s gearing range maximum is 25 per cent and it is currently 15 per cent geared.  You would know that the company would not suddenly take out a lot more gearing. In fact, it would probably not take out any more gearing, as it needs to allow sufficient ‘headroom’ in case markets fall. Of course, if markets were to fall by 35 per cent overnight, then you might find the gearing range maximum being temporarily exceeded by a small amount. 

This is why we have the ‘normal market conditions’ in there, to prevent boards having to set unrealistically high gearing caps, and potentially confuse investors about their intentions where gearing is concerned, for fear of what might happen if another banking or eurozone crisis suddenly flared up.

Asking boards to make statements relating to the future is not an easy thing to do, and it was on this recommendation we were most cautious about what the response would be.  However, we have been delighted with the take-up, with 100 members already producing this information, which represents a very substantial proportion of our members who use gearing as part of their investment strategy.

If you take the average of the gearing range maximums, this comes to 23 per cent.  This is exactly what we would have expected, but we hope this will provide comfort to investors and their advisers so that they can begin to focus a bit less on the risks that gearing brings, and more on the potential benefits as part of a balanced, long-term portfolio.

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Ian Sayers is director general at the Association of Investment Companies