Investment trusts

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7. Gearing

The expression 'gearing' refers to the situation in which an IT increases the funds at its disposal by borrowing. It does this by issuing loan stock to institutions who lend capital in return for a fixed rate of interest.

Gearing can be good news or bad news for investors in an IT, depending on whether the IT does well or badly. If it does well, the gearing will magnify the benefit. If it does badly, the gearing will magnify the poor performance.

Example

• On launch, an IT issues 50 million shares at £1 each. It adds to the £50m by borrowing £10m bringing total funds to £60m.

The net asset value per share is £1.00 (£50m / 50m)

• Six years later, the value of the IT's portfolio has risen to £110m. After deducting the loan of £10m, it is £100m.

The NAV is now £2.00 (£100m / 50m).

• Whilst the value of the fund increased by a factor of 1.83 from £60m to £110m, the share price has risen by a factor of 2 from £1.00 to £2.00. That's because of the gearing.

Of course, gearing cuts both ways.

Example

• If the value of the same IT now falls by 25% from £110m to £82.5m,

The NAV drops to £1.45 (£82.5m - £10m / 50m).

• The decrease in share price from £2.00 to £1.45 is however more than 25%. It is 27.5%.

If you don't follow the maths of this example, it doesn't matter. The important point is that gearing increases the risk of a trust, but also makes it potentially more profitable.

1. What are investment trusts? 2. What does an IT do? 3. Difference from unit trusts 4. IT specialisation 5. Tax advantages 6. Discounts: the share price of ITs 7. Gearing 8. Split capital trusts 9. Warrants 10. Ways of investing in an IT 11. Factors to consider when choosing an IT 12. Where to find information about ITs 13. Conclusion