Enhanced income funds explained

These are tough times to be advising income investors. Interest rates anchored at an historic 0.5% low for the past seven years and dividend stalwarts such as Barclays, Glencore and Rolls-Royce cutting their shareholder returns in recent months have hit many who invest to supplement their income or pay their bills in retirement.

Advisers, however, have options to discuss with their income-hungry clients that could generate attractive yields on their savings.

‘Enhanced’ or ‘Maximiser’ equity income funds offer investors higher dividends by selling the potential capital gains of the equities owned by such funds. They use derivative trading to boost income, a strategy known as writing covered call options.

The tactic allows Schroder Income Maximiser (GB00B53FRD82) to offer a yield north of 9% despite volatility hitting the FTSE 100 in the past year and a raft of disappointing corporate results since the start of 2016.

The yields offered by other enhanced equity income funds also look attractive.

Best performing UK Enhanced Income OEICs over the past five years

Enhancing your returns

Covered call options are not as complex as they might sound to some clients. Essentially, a fund manager sells an option, giving the purchaser the right, but not an obligation, to buy a stock from the fund at a pre-determined ‘strike’ price on a specific future date.

For this service, the fund receives a premium regardless of whether the option is exercised or not. So in some respects a covered call option works rather like an insurance policy.

If the stock’s price does not hit the strike price by the time the contract expires the fund keeps the premium, which is distributed to investors as a dividend.

If the strike price is reached the fund still keeps the premium, but it has to pay any additional increase in the stock’s value over and above the strike price to the purchaser.

Using a covered call strategy allows funds to boost income from the premiums received, while giving up some capital upside when their stocks exceed the agreed future price. So advisers need to ensure that their clients are prepared to hand over their potential capital gains to receive an enhanced yield.

Target market

Enhanced equity income funds are for savers who invest for dividends and are not too concerned with capital growth. This makes these funds ideal for those accessing their pension pot through income drawdown to pay more for short-term requirements.

Such funds are therefore not as suitable for clients with long-term investment needs. They may currently yield more than a traditional equity income fund, but this might not be the case in five years’ time due to traditional equity income funds having more potential for dividend growth.

Schroder Income Maximiser has a three-year annualised return of 4.6%. This compares to a 6.4% return for the ‘traditional’ version, Schroder Income (GB00B5WJCB41). Likewise, Fidelity Enhanced Income has a three-year annualised return of 5.5% whereas its sister fund, Fidelity MoneyBuilder Dividend (GB00B3LNGT95), has returned 7.5% over three years.

The returns of the enhanced funds are not for long-term investors

Source: Datastream

Consider the risks

All investments carry risk and using derivatives to generate income is no exception. Alongside the option strategy, stock selection is a risk advisers and their clients need to consider before investing in such a fund.

Enhanced equity income funds invest in the same companies as their conventional UK equity income versions. The underlying investments are mainstream shares, not distressed investments that may offer a high yield to reflect the increased risk they carry.

Advisers need to make sure their clients understand that to generate premium income these funds could lean towards higher yielding equities. Chasing such investments increases the risk.

The issue with equities that pay high dividends is that those shareholder returns are vulnerable to a cut or being scrapped all together if the company hits a rough patch and cannot afford to increase or maintain its dividends at the previous year’s level.

A look at the top 10 holdings in Schroder Income Maximiser’s portfolio highlights that it holds stakes in companies with high yields, but skinny earnings cover. One such business is drug-maker and consumer goods group GlaxoSmithKline, which along with the fund’s other holdings, such as BP, Royal Dutch Shell and HSBC, has been the subject of speculation that it cannot afford to maintain or grow its dividend at the current level.

Volatile times

A benefit of investing in an enhanced equity income fund is that they are typically less volatile than their mainstream versions. If the market falls, enhanced income funds have a higher yield to cushion the total return.

On the other hand, if there is a market rally the value of these funds won’t rise by as much due to management giving up some of the growth for the yield. This, however, is not guaranteed and of course depends on the skill of the individual manager running the fund.

Managers of these enhanced funds should expect to get a better price for the options when equities are volatile. If there is a dividend cut in a particular share the volatility of that share increases, resulting in higher premium prices for the options they sell on behalf of the fund. This can compensate clients for the cut in dividend payments.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.