Investors planning a return to equities are being advised to consider highly leveraged investment trusts, which have the potential to outperform a rising market.
These trusts borrow money to invest – and so can magnify, or ‘leverage’, the returns from rising share prices, provided their gross assets rise at a faster rate than the level of interest due on the debt.
This ability to borrow money, or “gear up”, is seen as an advantage that investment trusts have over similar savings vehicles, such as unit trusts, as it can allow them to take greater advantage of investment opportunities.
“If you think there could be a turnround, and see equities going higher from here, then geared investment trusts should see more upside,” says Mick Gilligan at Killik & Co.
Normally, investment trusts might gear up only 10 to 15 per cent of their assets. Now, many have gearing of over 30 per cent.
In part, this is simply because the net asset values of investment trusts have fallen, so their debt represents a greater proportion of their assets.
But, with the outlook for markets still uncertain, analysts at Oriel Securities say investors need to understand how much debt an investment company is in, as this will affect its performance.
“Markets have been so volatile that we wanted to see who will be the losers and the beneficiaries of any rise or fall,” says Iain Scouller, investment trust analyst at Oriel.
Trusts with higher levels of debt include Edinburgh Investment Trust, Scottish Mortgage and Finsbury Worldwide Pharmaceutical.
Nick Greenwood, manager of the Iimia investment trust, which invests in other investment trusts, has just added the leveraged Jupiter European Opportunities trust to his portfolio, which he says trades on a wide discount of 25 per cent, in spite of a decent long- term performance record.
The Jupiter fund is similar in investment mandate to the Gartmore European fund, which trades on a much lower discount of 5 per cent.
“There’s an opportunity here as you’re getting in cheaper to the leveraged fund as people are fearful of leverage,” he argues.
But some analysts point out that not all highly-geared trusts have money lying around that they can invest straight into the market.
“Whether the gearing provides flexibility to invest in new opportunities depends largely on whether the borrowings have been deployed or not,” says Gilligan. “In most cases, highly-geared trusts are already close to fully invested.”
Not all leverage is cheap, either. Some trusts took out loans at fixed rates when interest rates were a lot higher – these include Edinburgh Investment Trust and Merchants. Gilligan reckons the effect of this debt is to take about 7.5 per cent off their net asset values.
Highly-geared investment trusts also run the risk of not being able to refinance their debt. Gilligan says that, for this reason, Killik is avoiding investing in any highly-leveraged funds or companies, as it believes the financial crisis will continue for some time.
