Can borrowed money boost returns?

Donald Trump’s election may have hinted at the beginning of a return to a more conventional era in the bond markets, but the future of stock markets is far less certain. Arguably, however, conditions are just right for a certain type of investment trust.

Higher inflation is expected, which is normally a boon for stocks, in moderation at least, as businesses hitch a ride on economic growth. On the other hand, central banks’ policies over the past decade – pumping trillions into the global economy – are widely credited with propping up share prices. We don’t know how markets will cope if, as it now appears, central banks are about to curtail these measures.

But investors who are inclined to bet on the idea that Mr Trump’s policies will ultimately boost shares face a choice: whether to invest in the stock market via an ordinary “open-ended” fund or via an investment trust.

One argument in favour of the latter is that investment trusts are able to borrow money in order to invest more in the shares they choose. This practice, known as “gearing”, is often touted as an attraction of the investment trust route as it is not available to open-ended funds.

Using borrowed money amplifies both gains and losses, so a trust that uses gearing is an attractive option in rising markets but potentially dangerous when they fall. It is much like buying a house with a mortgage: the return relative to your deposit can be huge if you have a large mortgage and house prices rise, but a relatively small decline in the market can wipe out most of your equity. The more borrowing a company or investment trust has, the greater the risks.

So as we enter a period of heightened uncertainty in the markets – driven by a Trump presidency and Brexit negotiations – the degree to which an investment trust uses gearing is an important consideration for investors.

Telegraph Money has crunched some numbers to see whether the funds that use borrowing have delivered superior returns as a result.

Some sectors – notably property – use borrowed money to a far greater extent than others, while many funds have a policy of not borrowing at all. Over the past five years, the average gearing for trusts in the Asian property category was 45pc, compared with just 13pc for UK equity income funds, according to data from the Association of Investment Companies, the investment trust trade body, and Morningstar, the investment analyst.

We drilled down into the hugely popular global sector, which includes stalwarts Scottish Mortgage and the Lindsell Train investment trust.

The Majedie investment trust has had gearing of 23pc on average over the past five years, by far the highest figure in the sector. The £4.2bn Scottish Mortgage fund had the second highest borrowing, 15pc, allowing it to deploy an extra £550m.

Adrian Lowcock, of Architas, the fund group, said Majedie’s performance – disappointing over the past 12 months but seventh best over five years – showed how gearing could help beat the average over the long term. Yet nearly half of the 25-strong sector does not borrow any money at all.

Tom Stevenson of Fidelity, the investment firm, said the performance figures didn’t prove that gearing worked. “Six of the trusts in the sector had gearing of more than 10pc five years ago. Two – Scottish Mortgage and Witan – used their borrowings to good effect and appear in the top five performers over five years. However, Edinburgh Worldwide and Monks failed to derive any benefit, ranking 14th and 18th respectively.”

Three of the five best-performing funds employed little or no gearing. Lindsell Train, for instance, has been the best performing trust in the sector over the past one, three and five years – giving investors a total return of 74pc – and does not borrow money.

“This prompts the question of what they could have achieved had they used borrowed money in addition to shareholders’ funds,” Mr Stevenson said. “But equally it is possible that the highly geared underperformers might have done better if they had stuck to their knitting and just focused on buying the right stocks.”

James Budden of Baillie Gifford, which manages Scottish Mortgage, said investors should not fear funds

Funds that use ‘gearing’ hope to make bigger gains, says Sam Brodbeck

that borrow unless levels became unreasonably high. Questions should be asked if a fund has gearing of 30pc or more, he said, although property funds are an exception as using borrowed money to invest here is the norm.

Mr Budden also warned against funds that try to time markets, increasing or decreasing borrowing in line with their stock market expectations. “Invariably, these calls go wrong,” he said, adding that it was far better to maintain a steady level of borrowing no matter what.

Many financial advisers are also fearful of gearing – it’s the biggest reason for advisers not to recommend investment trusts to their clients.

But many people hold buy-to-let properties as an investment, almost always using a mortgage.

A typical purchase might involve borrowing 80pc of the value of the property – but very few investment trusts will ever borrow anywhere near this amount.

‘Gearing can be an attractive option in rising markets’

Singapore’s financial district: average gearing for trusts in the Asian property market was 45pc over the past five years