For example, if an Investment Trust holds $100m in assets, and borrows a further $10m, it will have $110m in assets invested and hopefully generating a return. This is referred to as 10% gearing. The Manager can use this borrowed cash to take larger positions in conviction stocks, or take advantage of new opportunities without having to sell down other assets within the portfolio. Provided the investment manager can earn a return in excess of the interest on the loan, it can work well for shareholders in rising markets. As share prices rise, the value of a trust will rise faster.
However if markets fall, the investment manager may lose money. Any falls are magnified by the gearing and the $10m loan still needs to be repaid. There may be occasions when a loan needs to be repaid on a day when asset prices are low, forcing managers to sell at the bottom of the market. In these circumstances gearing can have a negative effect on returns for shareholders. Geared shares will fall faster than ungeared ones.
Not all investment funds are allowed to employ gearing but for those than can the effect of some moderate gearing has usually been positive. This is true over much of the last decade as markets have risen. It helps to explain why a geared Investment Trust has generally outperformed similar non geared investments over that time.
Whilst the shorter term falls have been magnified by gearing, there is no doubt that longer term usage can be advantageous.