Rising interest rates, volatile markets, cost disclosure concerns and geopolitical conflicts in Ukraine and the Middle East have contributed to discounts across the UK investment trust sector not seen since the depths of the Global Financial Crisis.
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The average discount across all investment trust sectors stood at 16.9% at the end of October, the widest discount for a month-end since December 2008, when it reached 17.7%, according to data from Morningstar.
Performance has lagged against this backdrop, with the average investment company up only 2% in the first ten months of this year, according to data from the Association of Investment Companies.
There have been questions about whether investment trusts should be using gearing during these uncertain times, particularly in light of significantly higher borrowing costs as central banks hike interest rates to bring inflation back to its 2% target.
Despite this, the AIC's communications director Annabel Brodie-Smith was positive that the average investment trust currently runs 7% gearing because this mechanism is a "structural benefit" of the sector to boost returns.
"Gearing is when a company borrows to invest in a particularly attractive opportunity without having to sell existing investments," she said. "The idea is that the additional investment makes enough money to pay off the loan and makes a profit on top of that."
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Simon Elliott, investment trust client director at JP Morgan Asset Management, said the decision to deploy, increase or cut gearing was "part and parcel" of the investment trust sector.
"Many investment trusts have an established range of gearing that encompasses changing market conditions, and this can be helpful for investors in understanding the strategy," he explained.
An investment trust board will be involved in setting that range and are party to procuring sources of gearing, he noted, be it through credit facilities, longer-term loan arrangements or instruments such as CFDs.
Higher cost of debt
During the Covid-19 market crash in 2020, investment trusts were able to take on debt and buy shares at cheap prices, which Charlotte Cuthbertson, fund manager at Asset Value Investors, said helped create "outstanding returns" when the market bounced back later on.
While open-ended funds were having to sell their investments to meet redemptions, trusts "were able to take advantage of the market malaise", she added.
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But now, after a decade-long period of near-zero interest rates, the macroeconomic environment has moved into a new paradigm where the cost of debt is significantly higher, which has fuelled an equity bear market.
According to Cuthbertson, this has meant that many trust managers seem to be more cautious about gearing up than in the past. For trusts that are in the alternative space, she said this was an even trickier call to make.
"Rising interest rates have made the cost of debt more expensive and so managers are needing better returns from their assets to justify the investments," she said.
"On the other hand, trusts that were able to raise money again and again from the market have seen this dry up. For these trusts they have no choice but to gear up if they want to make follow-on investments or fund their pipeline."
Infrastructure, renewable energy and other alternative income funds were some of the casualties of this environment, she noted, with many now at the limits of their gearing abilities.
Cuthbertson pointed to Digital 9 Infrastructure as an example of how taking too much debt can go "horribly wrong", with the managers now exploring the sale of their crown jewel Verne Global to pay down the debt.
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"There is no easy answer as to whether trusts should use gearing. It can be a great boon to performance but can also cause chaos if not used properly," she said.
"What is clear, is that in the new world with debt more expensive than it has been for a decade, the stakes for trusts are even higher."
Taking advantage of opportunities
Gearing is not without risk, noted the AIC's Brodie-Smith, as it has the effect of magnifying performance in both strong and poor markets. Over time, however, she argued "it can really add value".
"In stressed market conditions, it may seem counterintuitive to be taking on more borrowing. However, in the long term it can make sense to buy assets when they are going cheap," she said.
"Many investment companies have borrowing arrangements in place similar to an overdraft facility, so they can dip into it when they see attractive opportunities."
JP Morgan AM's Elliott said gearing can be a "double-edged sword", but that the ability to gear was "one of the unique advantages" of the investment trust sector.
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"If you believe that a particular asset class will generate a positive long-term return, continuing to deploy modest levels of gearing can make considerable sense despite short-term volatility," he said.
Brodie Smith noted that while the cost of gearing has increased, many trusts are locked into attractive long-term debt from when interest rates were low.
"It is also important to understand that not all trusts use gearing, many use it modestly and the amount of gearing varies from sector to sector and from trust to trust. But over the long-term investment trusts' ability to gear is an advantage over other funds," she added.
James Hart, investment director at the £1.7bn Witan Investment Trust, said that most equity markets are attractively valued despite geopolitical and economic uncertainties, which justified his "relatively high" level of gearing of around 15%, he noted.
Hart argued that global equity trusts should be "watchfully" employing gearing in the current market environment, as there is a "plethora of cheap opportunities" in equities around the world, with exception of the tech-dominated US market.
According to the AIC, Witan Investment Trust is currently trading at a 8.2% discount to net asset value, which Hart said was historically wide.
"If we are right, and if equities perform well in the months and years ahead, it is entirely reasonable to expect investors to benefit from a ‘double whammy effect' of being geared into a recovery in the valuation of our portfolio as well as a narrowing of the discount at which our shares trade," he added.