A novel strategy for income
A growing number of investors are looking for a high income from their investments, without taking excessive risk. It is still possible to obtain decent levels of income, but you may need to cast your net more widely. One innovative approach uses derivatives to enhance income; the Schroder Maximiser funds are the best known of these. I have used them as an example later.
A survey conducted in December by Schroders showed that 92% of respondents hope to achieve an income of 4% or more, while 41% target a somewhat ambitious 8%. Does this reflect a mismatch between expectations and reality? Baby boomers might remember when they could get 8.75% on 5-year national savings accounts yet the best 5-year savings term today is below the inflation hurdle of 2.6%. What’s more, a decade of quantitative easing has left government bond yields at similarly unappealing levels.
Since attractive returns from savings accounts or government bonds are hard to come by, many have turned to higher-risk sources such as dividends or interest from high yield bond coupons. The economic recovery of the last few years has allowed companies to deliver a growing stream of dividends, along with healthy capital growth which can be locked in to supplement income.
However, as the cycle matures, income may make up a greater part of returns in coming years. Therefore, strategies which enhance dividend income and potentially reduce equity volatility could become very popular.
How does the ‘Maximiser’ strategy work?
It involves the use of derivatives; the manager sells the right, but not the obligation, to buy shares already held by the fund. This is known as a covered call option. The exercise price is agreed upfront and the option will expire after a fixed date. In return the fund manager will get a small fee.
If the shares rise above the exercise price, the option holder will exercise it and benefit from the additional upside. On the other hand, if the shares remain below the exercise price, the option holder will let it lapse. The fund keeps the income it received from selling the option.
The options strategy is actively managed, and not all holdings in the fund will have an option on them, to generate some additional income for the fund. Using Schroder Income Maximiser fund as an example - the core investments in the fund are managed using the same philosophy as the Schroder Income fund, so the base yield for the Maximiser fund is the same, at around 3.5%, with an extra 2.5-4.0% targeted from the call options revenue.
Does it mean more risk?
Because they are selling derivatives on companies they already own, the only ‘risk’ associated with selling call options is that you may miss out on part of the upside. Unlike some funds, they do not use complex derivatives to achieve their objectives, such as going short of stocks they do not own.
For risk averse investors, this is one of the less risky ways of boosting your income.
What are the advantages and disadvantages of the strategy?
Some future capital gains are likely to be surrendered and these funds will under-perform a similar portfolio with no derivative overlay if stock markets are rising strongly. On average, participation in capital growth is reduced to about 85%.
However, when markets are falling they tend to out-perform as the upfront option premium can help to cushion the fund from the full impact. This can smooth returns at times of heightened volatility; even in bull markets there are times when markets fall.
As with any investment in shares, there is always the possibility the capital value can fall as well as rise and the dividends paid are not guaranteed, therefore you should have a medium to long-term horizon.
What funds are available?
Schroder Income Maximiser
is managed by the value team who we hold in high regard, who are also responsible for the Schroder Income and Schroder Recovery funds. Other funds which adopt a similar strategy, and are also found in the UK Equity Income sector, include: Fidelity Enhanced Income
, Premier Optimum Income
and Insight Equity Income Booster
Schroder’s also offer the same strategy in their Schroder Asian Income Maximiser fund
. To investigate such funds further, you can also filter by yield in :explore.
As these strategies have met their objectives to date, I would expect to see more funds launched with a similar mandate.
In conclusion, this strategy can play a valid role in an income seekers’ portfolio, but you should always consider each fund on its own merits, and conduct research to ensure the fund manager’s style, philosophy and process is suitable for your goals. Given these funds have shown defensive qualities in periods of market weakness, they may also play a useful diversification role within a portfolio.
Important Information: We do not give investment advice so you will need to decide if an investment is suitable for you. If you are unsure whether to invest, you should contact a financial adviser.