Investment trust gearing: what borrowing means for your money

Investment trusts can borrow money to make additional investments, and this is called gearing¹. It is one of the features that sets them apart from other kinds of fund. The aim is to enhance returns for shareholders, but borrowing cuts both ways: gearing can help to boost performance in rising markets, and it can amplify losses when markets fall².

The more an investment trust borrows, the more risky it is¹. Interest on the borrowing must be paid whether the trust profits or not³. A trust with a gearing rating of 100 has no borrowing, while a rating of 110 means gains or losses are magnified by 10%⁴.

Gearing is not a guarantee of better returns. It is a choice each trust makes, and it is disclosed. The AIC publishes details of each trust's gearing policy, so you can check before you invest⁴.

Gearing means an investment trust borrows to invest

An investment trust is a way to make a single investment that gives you a share in a much larger portfolio⁶. It is a type of collective investment which allows you to spread your risk and access investment opportunities that you would not be able to invest in on your own¹. Investment trusts are sometimes called investment companies, because each one is a company in its own right with an independent board of directors whose job it is to stand up for your interests⁶.

Unlike most funds, an investment trust can borrow money to make additional investments¹. This is gearing. The trust might take out an ordinary bank loan, or issue special kinds of shares that work like IOUs¹. Investment trusts can usually borrow at lower rates of interest than you would get as an individual¹.

The borrowed money is invested alongside the trust's own assets. So if a trust has £500 million of net assets and uses 10% gearing, it borrows £50 million, and £550 million is working in the market². The trust pays interest on the £50 million regardless of how the investments perform³.

Gearing is not the same as the discount or premium at which investment trust shares trade. More often than not, investment trust shares tend to trade at a discount to the value of the underlying assets¹. That is a separate feature of the structure, and it can add to volatility alongside gearing⁵.

Why investment trusts borrow: the aim of higher returns

The goal of gearing is to enhance returns for shareholders². If the trust's investments earn more than the cost of the borrowing, the extra money working in the market benefits shareholders. Investment trusts can borrow and use gearing to take advantage of opportunities³.

There is a structural reason investment trusts can do this. They issue a fixed number of shares when they are set up, which investors can buy and sell on the stock market⁵. Because they have a fixed number of shares and are publicly listed, they can borrow money to make additional investments⁷. An open-ended fund has to issue and cancel shares as investors join and leave, so its size fluctuates with demand.

Borrowing also lets a trust take advantage of opportunities without asking existing shareholders for more money. The trust can act when it sees value, rather than waiting to raise fresh capital.

The cost of the borrowing matters. Interest must be paid whether the trust profits or not³. If the trust's investments earn less than the interest bill, gearing works against shareholders. That is the trade-off at the heart of gearing: it can boost returns when markets rise, but it adds a fixed cost that has to be covered first.

Investment trusts can also smooth the income they pay out from year to year by reserving income in good years to pay out later¹. That is a separate feature from gearing, but it is another way the structure gives managers flexibility that open-ended funds do not have.

Gains magnified when markets rise, losses when they fall

Gearing magnifies whatever the underlying portfolio does. In rising markets, gearing can help to boost performance². In falling markets, gearing can amplify losses².

Here is how the magnification works in practice. A gearing rating of 100 means the trust has no borrowing. A rating of 110 means your gains or losses will be magnified by 10%, which is gearing of 10% of total assets⁴. So if the portfolio rises 10% and the trust is geared at 10%, the gain to shareholders is larger than it would have been without borrowing. If the portfolio falls 10%, the loss is larger too.

The same principle applies to the trust's own share price. Investment trusts trade on the stock market, which means their price can move up or down throughout the day⁸. Gearing affects the value of the underlying assets, and the share price moves in response, sometimes further because of the discount or premium.

A worked example helps. If you have £1,000 invested and the manager gears by 10%, this equates to £1,100 working for you in the investment⁹. The extra £100 is borrowed. If the investment rises 10%, the gain is on £1,100 rather than £1,000. If it falls 10%, the loss is on £1,100, and the interest on the £100 still has to be paid.

The more a trust borrows, the more risky it is

As a rule, the more an investment trust borrows the more risky it is¹. That is because the magnification cuts both ways, and because the interest bill is fixed. A trust with high gearing needs its investments to earn more than the cost of the borrowing just to break even.

The combined effect of gearing and the discount means investment trusts are likely to be more volatile than equivalent funds⁵. Volatility is not the same as loss, but it means the value can swing more sharply, and a geared trust can fall further than an ungeared one in a downturn.

Investment trusts are more risky than bank savings accounts but offer the chance of a growing income and potentially capital growth too¹⁰. They are not suitable for everyone. The AIC lists the circumstances in which they may not suit: if you have an investment time horizon of less than five years, need a guaranteed return, need a guaranteed income, or cannot accept the risks that come with gearing and discounts¹.

Some types of trust carry more risk than others. Venture capital trusts (VCTs) are higher risk than most other investment trusts because of the companies they invest in¹¹. VCTs are typically very high-risk investments, where losses could eclipse tax savings¹². Real estate investment trusts can also be riskier than other trusts, in part because it is harder to sell the underlying real estate investments if investors withdraw their money¹³.

Charges vary too. Investment trusts that invest in more specialist assets, such as property, private equity or infrastructure, are likely to have higher charges than those that invest in more conventional assets such as shares or bonds¹⁴. Large investment trusts often have lower costs than smaller ones, due to economies of scale, which are often passed on to shareholders as trusts grow⁴.

Investment trust or unit trust: only one can borrow to invest

Being able to gear is an advantage investment trusts have over other kinds of fund, such as unit trusts, which are not permitted to borrow to invest¹. Open-ended investment companies (OEICs) cannot do it either. By borrowing money, a process known as gearing, investment trusts can potentially boost returns, though it can also magnify losses, something OEICs cannot do³.

The difference comes from the structure. Investment trusts are companies listed on the stock market with a fixed number of shares⁵. Unit trusts and OEICs are open-ended: they create and cancel units or shares as investors buy and sell, so their size rises and falls with demand. An open-ended fund that borrowed heavily could be forced to sell assets to meet redemptions, which is one reason the rules do not allow it.

For a saver choosing between the two, the practical point is that gearing is a risk you take on with an investment trust that you do not take on with a unit trust or OEIC. That does not make one better than the other. It means the risk profile is different, and the gearing rating is one of the figures to look at when comparing trusts.

If you want to understand the wider differences between the two structures, including how they are priced and traded, see investment trusts vs unit trusts and OEICs. For the basics of how investment trusts work, see investment trusts explained.

Is a geared investment trust riskier than one that does not borrow?

Yes. A geared trust carries the risk of the underlying investments plus the risk that comes from borrowing. The more it borrows, the more risky it is¹. A gearing rating of 100 means no borrowing; a rating of 110 means gains or losses are magnified by 10%⁴.

The extra risk shows up in two ways. First, the magnification: a fall in the portfolio hits shareholders harder than it would in an ungeared trust. Second, the fixed cost: interest must be paid whether the trust profits or not³. If returns are poor, the interest bill still has to be met, which can eat into income and capital.

Gearing is not automatically bad. In rising markets it can help to boost performance². But it is a risk that has to be understood, and it is one reason investment trusts are described as more volatile than equivalent funds⁵.

Is gearing the same as leverage?

They describe the same idea: the use of borrowed money to increase the size of an investment². Gearing is the term most often used for investment trusts. Leverage is more commonly used for other products.

Leveraged exchange traded products, for example, can have different levels of leverage, such as 2x or 3x, to multiply gains, but this also means that any losses are also multiplied¹⁵. Some can move in the opposite direction of the market, called inverse, so they go up when the value of the index falls¹⁵. Those are different products with different rules from an investment trust.

For an investment trust, gearing is usually expressed as a percentage of total assets, and the AIC publishes details of each trust's gearing policy⁴. The gearing rating makes it possible to compare trusts on a like-for-like basis: 100 means no borrowing, and a higher number means more.

Where to check a trust's gearing and what else to look at

The AIC publishes details of each trust's gearing policy⁴. That is the starting point if you want to know whether a trust borrows and by how much. The gearing rating gives you a number to compare across trusts.

Alongside gearing, it is worth looking at the trust's investment objective, which is the basis for how the AIC classifies trusts into sectors¹⁶. A trust's sector tells you what it invests in, which shapes its risk before gearing is added. Charges matter too: investment trusts that invest in more specialist assets are likely to have higher charges than those investing in conventional assets¹⁴.

Investment trusts are more risky than bank savings accounts¹⁰. If you are considering one, the AIC's guidance on whether investment trusts suit you lists the circumstances in which they may not: a time horizon of less than five years, a need for guaranteed return or income, or an inability to accept the risks of gearing and discounts¹.

For general help with investment risk and how it relates to your circumstances, see investment risk and your attitude to risk. For how charges work across funds, see fund charges and the ongoing charges figure.