This article looks at investment trusts and gearing, specifically the ability of trust managers to borrow money to invest.

With the help of industry body the Association of Investment Companies, we have crunched some data on gearing levels in the investment trust universe. Overall the average levels of gearing for trusts which invest in equities has remained pretty stable with gearing levels slightly higher than they were a year ago (as at the middle of March 2025) but bang in line with the five-year average at 6%.

However, by drilling down to an individual trust level, we have uncovered investment trusts which have meaningfully increased gearing over the last few years and asked some of the managers why they have done so and, more generally, how they think about gearing.

It is worth noting these conversations took place prior to the recent market turbulence.

WHY TRUSTS USE GEARING

If everything goes right the additional investments made will make enough money to pay off the loan, including interest and deliver a profit on top. Gearing also means fund managers do not have to sell holdings they still like if they have other investment ideas they want to action. 

On the other hand, gearing can also magnify losses, so it is important to understand how much gearing a trust uses and the conditions under which gearing might be increased or decreased.

It is worth pointing out that if net asset value falls, the level of gearing increases as debt becomes a larger proportion of total assets. This may force a trust to sell stocks at sub-optimal times to reduce gearing.

Before the pandemic when interest rates were very low, trusts could borrow very cheaply at 1% or 2% which made it easy for managers to generate a capital return or dividend yield above the cost of servicing the debt.

Since 2022 the cost of borrowing has increased significantly which has changed the equation considerably.

The maximum level of gearing is set by the trust’s board while the manager decides on the level, often in consultation with the board. Some trusts use gearing to boost income, others to boost capital returns.

DIFFERENT TYPES OF DEBT

Most trusts hold a mixture of fixed and variable rate debt. Shorter-term debt can be financed through an overdraft facility while longer-term debt can be taken on through fixed-rate loans.

It is worth mentioning that some trusts use derivatives to get exposure to certain markets while others invest in short positions, which are bets that share prices will fall.

This can mean the reported gearing overstates the actual level of market exposure. For example, BlackRock Frontiers (BRFI) reports gross market exposure as 123% (23% gearing) while the net exposure, including short bets is 114% or 14% gearing.

One type of funding which has gone out of favour in recent years is the use of ZDPs (zero dividend preference shares).They were issued by split capital trusts, which issue capital and income shares separately.

Split-capital trusts were embroiled in a big mis-selling scandal in the early 2000s when they became over-leveraged and suffered huge losses during the market downturn. Many split-caps invested in each other which made the damage even worse. However, some trusts still use these vehicles.

HOW DO ZDPs WORK?

ZDPs have a predetermined value which is paid to shareholders on a specific future date. These instruments can be traded on the stock exchange, which means they can be bought or sold at any time, subject to available liquidity.

ZDPs publish a ‘promised yield’ based on an investor holding on to maturity and the trust not going bust. They are relatively predictable and secure as they rank higher than ordinary shares in the event of a wind-up.

Zeros are helpful from a tax planning perspective because the return is taxed as a capital gain rather than income.

The top rate of capital gains tax is 28% (32% from April 2025) compared to top rates of income tax of 40% and 45%.

WHICH TRUSTS HAVE INCREASED GEARING?

Chelverton UK Dividend Trust (SDV) is a split-capital trust which invests in mid-cap and smaller companies to provide income and capital growth. The trust is managed by Chelverton Asset Management which was formed by David Horner in 1998.

AIC data shows gearing has increased to 60% from a five-year average of 49%. Horner is a big fan of ZDPs and believes they provide good flexibility compared with bank debt.

The trust deploys gearing to boost income and capital growth and has done so throughout the life of the trust.

The increase in gearing in this case reflects the movements in the value of the portfolio relative to the fixed amount of debt.

That said, Horner is positive on the prospects for companies in the portfolio which he believes are undervalued. The trailing dividend yield on the trust is 9.4% and the annual ongoing charge is 2.73%.

The company is in the process of raising new ZDPs to replace the existing facility which matures on 30 April.

EXPLOITING ATTRACTIVE OPPORTUNITIES

Gearing at Fidelity Asian Values (FAS) has moved up notably to 18% compared with a five-year average of 7%.

‘The level of gearing has increased in the last few years largely because we have been able to find more investment opportunities in China, a market which has been out of favour with investors,’ explains portfolio manager Nitin Bajaj.

‘We have always maintained that the level of gearing in the company remains a function of the number of investment ideas we find.’

Similar reasons were put forward by Baillie Gifford Japan (BGFD) when the company reported half year results on 28 March.

The managers wrote: ‘Given the highly attractive investment opportunities available and a low funding cost we have maintained net gearing at the significant level of 20%.’

Fund managers Ailsa Craig and Marek Poszepczynski at International Biotechnology (IBT) point out that investment trusts can take advantage of the ups and downs in the stock market to redeploy gearing and purchase quality stocks at appealing valuations.

‘As investment managers, we can adeptly adjust our gearing positions in response to shifting market conditions and sentiment. For instance, in our fund’s interim report dated February 2021, we reported a gearing level of just 2.3%, implying a very defensive stance regarding the market outlook.

‘Fast forward to the end of February 2025, and our gearing has increased to 11.5%. This significant rise reflects our heightened optimism about the fundamental sector outlook.’

It is a similar story at BlackRock Frontiers which, as the name suggests, focuses on frontier markets, effectively the rung below emerging markets.

Sudaif Niaz, co-manager of BlackRock Frontiers told Shares: ‘The net gearing of the trust has increased from 3.3% in February 2020 to 17.1% at end February 2025, which is around the same level of gearing that we employed one year ago.

‘The rise reflects our optimistic outlook on frontiers and smaller emerging markets, and the numerous bottom-up opportunities that we believe exists in these markets.

‘By increasing our gearing, we are strategically positioning the trust to capitalise on these opportunities, where the ultimate goal is to enhance returns for our clients,’ explained Niaz.

The ability of investment trusts to borrow money, done wisely and judiciously can enhance long-term returns for shareholders but investors should be aware of the risks associated with gearing, in particular their capacity to exacerbate losses. 

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