Most investment vehicles are funds run by companies where the basic rule is that they only invest the money that they have been given by individual investors.
Investment trusts and some funds can, however, borrow money (gearing). They tend to do so for the following reasons: –
- To smooth cash flow – an investment trust might want to make changes in a portfolio (especially buying new stock) but not want to sell any current positions at the same time. It borrows the money, repaying later when it does sell. Such activity would be common in general broad-based equity-oriented investment trusts.
- To take aggressive opportunistic positions – this is an extreme version of the above. The investment managers spot an opportunity and might want to commit significant assets to it, so they borrow the money. Investment trusts and funds that engage in this type of behaviour will normally be looking for one opportunity after another, and it should be clear from their description that this occurs.
- To provide gearing to shareholders – all borrowing provides gearing, but in some funds where the aim is to take an aggressive approach to making gains (and which tend to always be using significant amounts of borrowed money, rather than just a bit from time to time), it might be explicit that the fund is geared.
The higher the gearing, the higher the risk.
For example a fund might borrow 50p for every £1 that its shareholders invest. Let’s assume a current price of £1 per share.
If they do well and invest the £1.50 so that it grows to £3, the investors would get back £2.50, (the share price should rise to £2.50). A 100% fund gain produces a 150% gain for investors (before the interest on the loan is paid).
But if the fund managers turned their £1.50 into 50p, the lenders could call in the loan, get their 50p back and leave the investors with nothing.
- The power to issue different classes of share – This allows companies to issue different types of share, with different rights. The differences in rights lead to differences in expected risk and return, and these are suitable for different types of investor. This reaches its full development in split capital investment trusts.
The value of investments can fall as well as rise and you may not get back the amount you originally invested. Past performance is not a guide to future performance. Certain investments, such as those that borrow, can be high risk and may not be suitable for most investors – advice is essential.