Enhanced income funds explained

These are tough times to be an income investor. 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.

There are, however, options for income-hungry investors to earn an attractive yield 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 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

Source: Morningstar, Trustnet
Where more than one class of fund features only the best performer is listed.
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Enhancing your returns

Covered call options are not as complex as they might sound to some investors. 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 investors need to be 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 their bills.

Such funds are therefore not suitable for long-term investors. 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. Likewise, Fidelity Enhanced Income has a three-year annualised return of 5.5% whereas its sister fund, Fidelity MoneyBuilder Dividend, has returned 7.5% over three years.

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

Source: Thompson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

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 investors 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.

Investors need to 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 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 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 investors for the cut in dividend payments.

Investors need to understand that enhanced equity income funds are not a ‘something for nothing’ investment. You are swapping potential future capital growth for higher immediate income so these funds are about rearranging a return profile rather than creating new value.

Remember that there are no guarantees that these funds will meet dividend expectations and before investing your hard-earned cash you must do your homework and decide if the investment meets your goals, appetite for risk and time horizon.