What is gearing and how does it work?

When you are researching the world of investment companies, you will notice many of them have something on their balance sheets called gearing. If you are thinking of investing, it's important you - and your financial adviser - understand what it is and the risks involved.

Gearing is the process whereby investment companies borrow money to buy assets in order to boost their income and returns for investors. This money is used to make additional investments, giving the company the chance to take advantage of particularly attractive stock, for example, or to carry out a long-term plan without having to sell existing investments in order to fund the purchases.

The idea is that the additional investment then makes enough money to pay off the loan and to make a healthy profit on top for investors, too.

Gearing is another fundamental difference between investment companies and open-ended unit trusts, with the ability to borrow one of the reasons that investment companies historically outperform their open-ended counterparts over the long term.

As you might guess though, gearing is not without its risks. Gearing magnifies a company's performance, whether good or bad, and increases the short-term volatility investors are exposed to. The more geared a company is, the higher the risk.

The Association of Investment Companies (AIC) cites the following example. Say you were invested in a company that has a gearing level of 10% (this means that the company's debt level is 10% of its overall equity). If the company was to see a drop in its value of 20%, then the gearing means, theoretically, that the loss would be magnified to 22%, while if there was a 30% drop in asset values, that loss would be magnified to 33%.

On the other hand, if there was an increase in asset value of 10%, then you would see an actual return of 11% and so on.

Given the nature of borrowing and the risk of magnifying losses, it's understandable some investors and advisers raise concerns about investment companies that have a high level of gearing. But the level of gearing varies between companies and sectors: 59% of the investment industry is not geared at all, while many companies are only geared at a very small level.

Overall, the average gearing level for all investment companies is around 7%.The Global Equity Income sector is at the higher end of the gearing spectrum, with an average level of 14%, while at the opposite end the Global Emerging Markets sector has an average level of just 1%.

In order to fund their borrowing, companies with a gearing strategy will often use a conventional bank loan – albeit at a much better rate than a normal customer would get with a far more reasonable repayment plan – as it gives the fund manager a level of flexibility over their investment options.

Some companies will have fixed- rate borrowing in place over a long period of time. In 2014, City of London and Perpetual Income and Growth both took out long-term loan agreements, with Perpetual issuing £60 million of debt over a period of 15 years at an interest rate of 4.37% in order to achieve successful returns.

“This was considered by the board to be attractively priced and the idea is that the manager can use this alongside the company's short- term bank overdraft facility,” a spokesperson for the AIC said.

“Providing the company can generate a total return of more than 4.37% on the investment of this money, this should mean extra returns for shareholders.”

When researching where to invest, bear in mind companies can also be exposed to the risk of borrowing via something called 'indirect gearing'. This is where one company, which may or may not have any gearing itself, invests in another one that does.

For this reason, many fund of funds (an investment company that invests in other investment funds) often have no gearing themselves as they are exposed to it indirectly.

For example, JPMorgan Elect Managed Growth has no gearing but has holdings in JPMorgan Claverhouse (18% geared) and JPMorgan American (10% geared). Like anything when it comes to investing, you and your adviser's research is key – the more information you have on a company, the better your understanding will be.

The AIC website provides information on the highest and lowest level of gearing over the past three years, while gearing range – what you would expect the maximum and minimum levels an investment company to be geared at in normal market conditions – is recorded as well.

Ultimately, gearing and the company's attitude towards it is just one of the many factors you need to consider before deciding where to invest your cash – a company with a high level of gearing may well be performing well and securing better returns for its investors, while one with little or no gearing may be performing below expectations.

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