Among the structural features that distinguish investment trusts from open-ended funds, gearing — the ability to borrow money to invest alongside shareholders' capital — is one of the most powerful, and one of the most misunderstood. Used well, gearing can enhance long-term returns for shareholders. Used at the wrong time, it can amplify losses just as effectively. This article explains how gearing works in investment trusts and the balance of risk and reward it introduces.
What gearing means in an investment trust context
Because investment trusts are structured as public limited companies with a fixed pool of share capital, they are able to borrow money — through bank loans, bonds, or other debt instruments — and invest the borrowed funds alongside shareholders' money, in pursuit of the trust's investment objective. This is a structural advantage most open-ended funds (OEICs, unit trusts, and most ETFs) generally do not have, since those structures are typically restricted from significant borrowing under their regulatory frameworks.
How gearing is expressed
A trust's gearing level is usually expressed as a percentage of net asset value — for example, "10% geared" typically means the trust has borrowed an amount equal to 10% of its shareholders' net assets and invested that additional amount into the market alongside its own capital.
How gearing amplifies returns — and losses
Because a geared trust has more total assets invested than its own net asset value alone, both gains and losses on the underlying portfolio are magnified relative to shareholders' capital, in both directions.
A simplified mechanical illustration
Consider a hypothetical trust with £100 million in shareholder capital that borrows an additional £15 million (15% gearing), investing the full £115 million in its target market. If that underlying portfolio rises by 10%, the total assets grow to £126.5 million. After repaying the £15 million borrowed (ignoring interest cost for simplicity), shareholders are left with £111.5 million — an 11.5% gain on their original £100 million, rather than the 10% the underlying market delivered. If instead the portfolio falls by 10%, total assets fall to £103.5 million, and after repaying the £15 million borrowed, shareholders are left with £88.5 million — an 11.5% loss, again larger than the underlying market's 10% fall. This is a simplified illustration ignoring borrowing costs, fees, and other factors, intended only to demonstrate the amplifying mechanism of gearing, not to represent any actual trust's structure or performance.
Why trust boards choose to use gearing
- To potentially enhance long-term returns for shareholders when the board and manager believe market conditions are favourable for the trust's asset class.
- To take advantage of the trust's permanent capital base and closed-ended structure, which allows borrowing arrangements to be planned over longer time horizons than an open-ended fund (which must remain ready to meet daily investor redemptions) could typically sustain.
- Some trusts use gearing tactically, adjusting the level up or down depending on the manager's view of market conditions, while others maintain a more consistent, structural level of gearing as part of their long-term strategy.
The additional risks gearing introduces
Amplified downside
As illustrated above, gearing magnifies losses just as it magnifies gains, meaning a geared trust can fall by more than its underlying market during periods of decline.
Interest rate and refinancing risk
Borrowing costs money, and rising interest rates increase the cost of servicing a trust's debt, which can reduce the net benefit of gearing, or even turn it into a drag on returns if borrowing costs exceed the return generated on the borrowed capital. Trusts with fixed-rate debt maturing at a future date also carry refinancing risk if interest rates have risen by the time the debt needs to be replaced.
Increased share price volatility
Geared trusts have historically tended to show greater share price volatility than similar ungeared funds, reflecting the amplified swings in underlying net asset value.
Timing risk
Gearing that is increased near a market peak, shortly before a decline, amplifies losses at precisely the wrong time — a risk inherent in any strategy that relies on the manager's or board's judgement about market timing.
How gearing levels vary across the investment trust sector
| Gearing approach | Description |
|---|---|
| Ungeared or minimal gearing | Trust invests close to its net asset value with little or no borrowing, behaving more similarly to an open-ended fund |
| Modest structural gearing | A relatively stable, low level of gearing (for example, 5-15%) maintained as part of long-term strategy |
| Higher or tactical gearing | Gearing actively adjusted by the manager based on market outlook, potentially reaching higher levels at times |
A trust's annual report and factsheet will disclose its current gearing level and its policy (including any maximum permitted level), which is worth reviewing before investing.
Considerations for investors evaluating a geared trust
- Check the trust's current gearing level and its stated maximum, alongside how it has varied historically.
- Consider how the trust's underlying asset class behaves in downturns, since gearing amplifies whatever the underlying portfolio does.
- Review the cost and structure of the trust's borrowing (fixed or variable rate, and maturity dates), as this affects sensitivity to interest rate changes.
- Consider personal risk tolerance and time horizon, since geared trusts are generally associated with higher volatility than ungeared equivalents.
Gearing versus leverage in other contexts
It is worth distinguishing investment trust gearing, which is typically a moderate, board-controlled, and disclosed level of borrowing against a diversified portfolio, from other, generally riskier forms of leverage such as leveraged ETFs (which use derivatives to amplify daily returns by a fixed multiple) or personal borrowing to invest. Trust gearing is generally considered a more measured, long-term structural feature, though it still carries meaningfully more risk than an equivalent ungeared vehicle.
Types of borrowing used to create gearing
Bank loans and revolving credit facilities
Many trusts arrange bank loans or revolving credit facilities, which can be drawn down and repaid flexibly, allowing the manager to adjust gearing levels relatively quickly in response to changing market views, though typically at variable interest rates linked to prevailing market rates.
Fixed-rate long-term debt
Some trusts issue longer-term debt, such as debentures or loan notes, at a fixed interest rate for a set period, sometimes decades. This provides certainty over borrowing costs for the life of the debt, but means the trust is locked into that rate even if market interest rates subsequently fall, and faces refinancing risk when the debt eventually matures.
Preference shares
A small number of trusts, particularly some longer-established ones, have historically used preference shares (which pay a fixed dividend before ordinary shareholders receive anything, but do not usually carry voting rights or share in capital growth in the same way as ordinary shares) as an additional form of structural gearing, functioning similarly in effect to fixed-rate debt from an ordinary shareholder's perspective.
How gearing policy is disclosed and monitored
UK investment trusts are required to disclose their gearing policy, current gearing level, and borrowing arrangements in their annual and half-yearly reports, and many boards set out a formal maximum gearing limit as part of the trust's investment policy, which cannot be exceeded without shareholder approval to change that policy. This provides a degree of transparency and a structural limit on how far gearing can be pushed without further scrutiny, though the specific maximum permitted varies considerably between trusts depending on their asset class and risk appetite.
Net versus gross gearing
Some trusts also hold cash or other liquid assets alongside their borrowings, and disclose a "net gearing" figure (borrowings minus cash and near-cash holdings, as a percentage of net assets) alongside or instead of "gross gearing" (total borrowings alone). Net gearing gives a more accurate picture of the trust's actual net market exposure relative to shareholder capital, since a trust with borrowings largely offset by cash reserves carries a very different practical risk profile from one with the same gross gearing figure but little offsetting cash.
Gearing across different asset classes
The effect and appropriateness of gearing can vary by the asset class a trust invests in. Gearing applied to a diversified, liquid equity portfolio behaves differently from gearing applied to a more volatile specialist sector, or to income-generating infrastructure assets with contracted, relatively stable cash flows. Reviewing gearing in the context of the specific underlying asset class, rather than as a single generic risk factor applied identically across all trusts, gives a more complete picture of what the borrowing actually implies for shareholders in that specific case.
A final consideration: gearing in the context of long-term compounding
For a long-term investor, the case for gearing rests on the belief that markets rise more often than they fall over sufficiently long periods, meaning modest, sustained gearing has the potential to enhance long-term compounded returns despite periodic amplified drawdowns along the way. This is a reasonable historical pattern for developed equity markets over many decades, but it is not a guarantee, and any individual investor's own time horizon may be considerably shorter than the multi-decade periods over which this pattern has generally held.
Comparing gearing across similar trusts as part of research
When comparing two trusts pursuing broadly similar strategies, checking and comparing their respective gearing levels, borrowing costs, and debt maturity profiles is a worthwhile part of due diligence, since two trusts with apparently similar historical performance may have achieved it with quite different levels of borrowed risk, which has implications for how each might behave in a future downturn even if their past returns look superficially comparable.
Key takeaways
- Gearing allows investment trusts to borrow money and invest it alongside shareholder capital, a structural feature not generally available to open-ended funds.
- Gearing amplifies both gains and losses relative to the underlying market, in proportion to the level of borrowing used.
- Rising interest rates increase the cost of gearing and can reduce or reverse its benefit to shareholders.
- Geared trusts have historically shown greater share price volatility than similar ungeared funds.
- Checking a trust's current and maximum gearing level, and the structure of its borrowing, is a useful step before investing.