How gearing can be used to enhance returns?

This video explains what gearing is and how it can be used to enhance capital returns.

Key takeaways

• Unlike other types of funds, investment trusts can borrow money through banks loans, overdrafts or private placement notes to fund the purchase of assets. This facility is called ‘gearing’.
• Gearing helps the manager to enhance capital returns in a rising market to generate extra income over the medium-to-long-term as long as those returns are greater than the cost of borrowing.
• Gearing increases volatility, therefore, any movement in the underlying assets’ values are magnified. Whilst returns are enhanced when markets rise, gearing exacerbates losses when investments fall in value.
• There are two forms of gearing, structural gearing, which relates to bank facilities and other conventional forms of borrowing and synthetic gearing – achieved through the use of more sophisticated financial instruments such as futures or options.

Glossary

Futures contract – A contract between two parties to buy or sell a tradable asset, such as shares, bonds, commodities or currencies, at a specified future date at a price agreed today. A future is a form of derivative.

Gearing – A measure of a company’s leverage that shows how far its operations are funded by lenders versus shareholders. It is a measure of the debt level of a company. Within investment trusts it refers to how much money the trust borrows for investment purposes.

Options – Options are financial instruments that are derivatives based on the value of underlying securities such as stocks. An options contract offers the buyer the opportunity to buy or sell-depending on the type of contract they hold-the underlying asset. Unlike futures, the holder is not required to buy or sell the asset if they choose not to.