Closed-End Fund Gearing Explained

In previous articles, we've already discussed what exactly a closed-end fund is and how to understand (and profit from) their discount. In this third installment of our new investment trusts series, we take a look at closed-end fund gearing and risks attached.

What Is Gearing?
Investment companies can borrow money in order to help finance the acquisition of their investment portfolio, with the hope of enhancing shareholder returns. This is known as “Gearing Up.” It gives the managers freedom to take advantage of a long term view, or quickly act upon a favourable situation with a particular stock (opportunistic gearing), without having to sell existing investments to raise the necessary funds. They may have all manner of flexible borrowing arrangements in place, which gives them the edge on unit trusts in this regard, as the latter have far more limited borrowing powers in terms of levels and maturity.

Why Do Companies Employ a Gearing Strategy?
Due to the size and status of investment companies, the manager can often negotiate borrowings at a reduced level and with far more flexible repayment terms than an individual could hope to achieve, enjoying the benefits of economies of scale. The managers would only borrow funds if they believe they could earn a higher return through investing than they are liable for in interest rate payments. They would also need to be mindful of any banking covenants and repayment due dates, so their hand was not forced into selling holdings in order to raise funds at inopportune moments.

Not all funds employ gearing, and it is usually clear at the outset in a fund’s prospectus if they will use a gearing strategy and if so to what extent. Bank loans will always rank ahead of share classes when it comes to the hierarchy of liabilities. This is important for an investor to know, as they will be last in the queue for money should things go very wrong.

Gearing can magnify shareholder performance returns in both directions. When the markets are rising it will improve performance beyond that achieved simply with the upward movement in the underlying holdings' share prices, but conversely losses will be exaggerated when the markets are moving the other way.

Gearing Effects
The above explanation can be better understood by working through an example:

A fund has net assets of £50 million and a bank loan of £10 million, amounting to gross assets of £60 million. If we assume the fund is fully invested and the underlying asset value rises by 10%, we have a new gross asset figure of £66 million: With the bank loan unchanged we have a new net asset value of £56 million. This compares to just £55 million if the fund was not geared and it enjoyed the same 10% market rise.

The gearing formula can be expressed as (Gross assets/net asset *100 - 100). A non-geared fund is said to have a gearing level of 100%. With all other things being equal, the more highly geared the fund the more risky it is for the investor. In a falling market the percentage level of gearing will rise as the assets fall, even with the actual amount of money borrowed remaining unchanged, this is riskier but for many it could also be seen as a fortunate by-product, as when markets are falling they would rather have more invested for the potential upside associated with a bounce back.

Net and Gross Gearing
A distinction should be made between net and gross gearing. If a £100 million fund has borrowings of £20 million, you would say it was 25% geared. However if it had £10 million of this tied up in cash or 'near cash', the gearing effect would be exaggerated as market movements would not impact this portion of the portfolio. The Gross Gearing calculation accounts for such non-equity holdings to therefore give a truer reflection of the potential gearing effect on the fund. We use the same formula as before but firstly take the cash figure off the gross assets. This would halve the gearing level in the above example.

Fair Value of Debt
As with any medium/long-term fixed coupon debt instrument, the market value or fair value of debt issued by investment companies is affected by movements in interest rates, credit quality and credit spreads. This has some implications for fund valuations, Edinburgh Investment Trust being a case in point. This fund has £200 million of long-dated debentures split into two tranches, paying coupons of 11.5% and 7.75% and maturing in 2014 and 2022 respectively. If the fund wished to repay this debt early, it would pay a premium of £48 million over the par value of £200 million. At the time of writing, calculating the NAV on this “Debt-at-fair-value” basis reduces it from 384p per share to 360p, and moves the discount from -8.9% to -2.8%. So you can see the importance of ascertaining the basis on which NAVs and discounts are calculated.

Structural Gearing
Although by far the most popular, gearing does not have to solely be in the form of bank loans and debenture stock (financial gearing). Among the most highly geared closed-end funds are what are known as split capital trusts. The gearing affect is obtained by prior ranking share-classes (structural gearing) as well as or instead of banking arrangements. This can often be cheaper or more tax efficient. We will investigate this split capital structure in more detail at a later date, but an investor should know that the individual gearing levels on some of these share classes can very easily be over 200%.

Summing Up
It is very important for an investor to know the level of gearing associated with the vehicle they wish to invest in, and to understand the risks attached to such a level. In bull markets, investors would be served well in a fund that had a high level of gearing and can therefore take full advantage of the rising markets. A fund may not currently employ any borrowings but one should know if the articles allow them to quickly become geared so the fund manager can purchase stocks they consider to be undervalued.

Unfortunately, in recent times all the worst performers are those that had the highest level of gearing. Many of those that had no gearing at all are at the top of the performance charts, albeit with negative returns, not necessarily because they had a manager making better investment decisions, but because of the fund's gearing strategy.