Should income hungry investors be looking at enhanced options?
People are living longer and with declining bond yields and rising inflation, the search for income has become harder as investors look to preserve their wealth.
One option for them is enhanced income funds which use derivatives called covered calls to lock-in a higher yield for investors. The yield on an enhanced income fund can be 7 per cent or more, which is very attractive in a low-return world.
Covered call options is a strategy where an investor holds a stock and then “writes”, or sells, a call option on the same stock to generate increased income from the asset. It is often used when a manager has a short-term neutral view on a stock in terms of where its price will go. The income is created from the fee the buyer pays the seller for the option, this is called the option premium.
The seller hopes the option expires, due to the stock not hitting the strike price, which is the price the buyer has agreed he would buy the stock. If shares rise above the strike price and the option is exercised, the seller cannot get more than the strike price for the shares.
It is for this reason that the funds are criticised by some for potentially sacrificing capital growth for income.
PSigma Investment Management chief investment officer Tom Becket says he is seeing great appetite for yield from clients, which makes enhanced income funds attractive.
Becket does not see the risk of giving up capital growth as a reason not to use the funds.
He says: “Total return needs to be the figure that is looked at. The total return has to be higher than the return on the income strategy.”
Bestinvest senior investment adviser Adrian Lowcock (pictured) agrees that investors need to look at total return, rather than just income when looking at these products.
He says: “Investors want income, but they do not want capital erosion at the same time. Often, the performance on these strategies is all through income and so a little bit of capital growth is sacrificed.”
He says the risk on enhanced income funds is that the manager gets the covered call option wrong, which will impact upon the capital return.
“If the price of the stock goes up, the buyer exercises the option and future capital growth is sacrificed for a guaranteed income stream now.”
Lowcock prefers enhanced income funds with an active management approach to stock-picking, rather than following an index.
He says: “Funds that follow the market are minimising risk, as there is no manager risk on the fund in terms of the underlying stocks, but there is not necessarily significant added value using this style.”
Lowcock says the covered call strategy works well in flat or sideways moving markets, but it is more difficult in a volatile market environment where prices move around quite dramatically.
Schroders head of structured fund management Thomas See says due to market volatility, only 66 per cent of the Schroders Income Maximiser has options on it.
He says 80 to 90 per cent of the fund has been previously covered by call options.
Schroders sells call options on a three-month basis on the Income Maximiser products, as he says this makes large enough trades to negotiate good prices.
See says: “I do not want to trade call options every day. We want to aggregate a good amount of options in each trade. We have to have large enough trades to negotiate good prices with buyers.”
BNP Paribas head of Harewood Solutions & Privalto UK Sisouphan Tran has a different approach in the £2m IFSL Harewood UK Enhanced Income fund.
This fund follows an index in terms of the stocks it holds and uses the strategy of covered call options to add value for the investor.
Tran says: “We sell call options on a daily basis, which is how we manage to reduce the volatility of our funds significantly. We sell calls at a higher frequency than most, which allows us to adapt much quicker to the market direction and derive more value from selling calls in terms of enhancing the yield.”
He adds: “This premium helps the fund create a cushion against the downside which explains why it is much less volatile than the market.”
Tran says using an index means the portfolio is less volatile, because it is much more efficient and you can sell calls at a higher frequency when you trade the market directly.
He adds: “Liquidity is much better and it is less costly to trade options on the index than a basket of stocks.”
Argonaut partner Olly Russ (pictured), manager of £57m Argonaut Enhanced European income fund, says they write calls on a monthly basis, as markets are so volatile that it would be difficult to predict where prices go over a longer period.
Only half of the fund is typically covered by options, as there is not enough liquidity in the market to cover a company smaller than a FTSE 100 stock and he holds smaller companies in the fund.
Russ says he manages the fund quite conservatively by not setting the strike price too low, as a lower price creates a bigger risk that the option will be exercised. Setting a lower strike price can allow managers to get a higher premium, however.
Russ says: “You are much more likely to be called on a stock if you set a lower strike price, but you will get more income for it. If you left it uncovered or set a higher strike price, it would be less likely to be working against you.”
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