Gearing
Gearing is the use of borrowed money to increase the size of an investment – also known as leverage.
It increases the level of risk involved. While a larger investment can lead to greater gains, it also means potential losses can be larger.
How investment trusts use gearing
An investment trust can borrow money to make additional investments, with the goal of enhancing returns for shareholders through gearing.
In rising markets, gearing can help to boost performance. However, when markets fall, gearing can amplify losses.
For example, an investment trust with £500 million of net assets uses 10% gearing to borrow £50 million. This gives the trust £550 million to invest.
If the market then rises by 10%, the portfolio grows to £605 million. After repaying the £50 million debt, the trust has net assets of £555 million.
However, if instead of rising, the market falls by 10%, the £550 million portfolio would drop to £495 million. After subtracting the £50 million debt, the trust’s net assets would be £445 million.
Compared to the original £500 million, this is an 11% loss, greater than the 10% fall in the market.