At a time when income is abundant, “enhanced income” strategies have been a surprise hit in 2023. The largest actively managed ETF in the world is now the JPM Equity Premium fund, a covered call strategy with $30 billon (£23.7 billion) in assets, while Morningstar identified “derivatives income” as its third most-popular strategy based on the number of funds launches over the past two years. In the UK, they remain a sleepier part of the market, but here too, they are gathering momentum.
Many of these funds launched in 2010 and 2011 in response to the paucity of income options as interest rates dropped following the global financial crisis. The theory was to combine the dividend income produced by a portfolio of companies with income produced by writing call options on the portfolio. The funds provided a solution for investors starved of income, often generating yields of 6%-7% at a time when interest rates were zero.
The price for this extra income was to give up a little of the fund’s potential upside. Fred Sykes, portfolio manager of the Fidelity Global Enhanced Income fund, explains the mechanics: “The fund sells the right to buy stocks at a fixed ‘strike’ price, at a specified point in the future. The buyer pays the fund a premium for that option and in return, the fund gives up some of the potential capital gains should the stock price be above the strike price at expiry.
“If the share has failed to achieve that price when the option matures, the option holder will not take up the right to buy it, yet importantly the fund will still keep the premium paid.”
The funds are based on a range of equity income strategies. The Schroder Maximiser range, for example, is built on the group’s UK, European, US, Asian and global dividend strategies. Fidelity has an enhanced income range, based on its MoneyBuilder and Global Dividend strategies. Premier Miton also launched a number of options based on its equity income funds.
The idea was sound, but their success or otherwise will be in the eye of the beholder. The funds have delivered a high income, while retaining exposure to stock market growth. Many have delivered a similar return to the fund on which they were based, but simply ensured that more of that overall return came in the form of income. For example, the Schroder Income Maximiser is up 19.7% over the five years to 19 November 2023. The Schroder Income fund on which it is based is up 20.8% over five years. The two funds have largely tracked each other, with the Maximiser fund slightly ahead in 2023, 2022 and 2019, and the normal fund ahead in the other years, but only ever by a few per cent.
However, there is no escaping the unpopularity of open-ended equity income strategies, which has weighed on the capital growth of these funds. The small drag from capping the upside has added to the problem, particularly in the buoyant markets of 2019 and 2020, and some of these funds still languish towards the bottom of the performance tables. This is fine if an investor is only looking for income, but may be disappointing for those who had hoped the funds would keep up with their peers.
Nevertheless, performance has been better since 2021. Not only have markets come round to the idea of equity income once again, the call-writing strategy has given an added source of return in lacklustre markets.
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In theory, the option-writing strategy shouldn’t exert a significant drag on returns. Geoff Kirk, co-manager of the Premier Miton Optimum Income and Premier Miton Global Sustainable Optimum Income funds, says the strategy is always strategic and strives to preserve the upside potential of the portfolio. They only ever write options on around half of the portfolio and will not write options on the companies with higher growth prospects. He says: “We work with the portfolio manager to identify individual stocks that have the ability to jump up during the option period: could a company be subject to a bid, for example? Is a company more sensitive to earnings? Is a stock beaten up?”
Sykes agrees: “Stock valuation and fundamentals are key in managing the call overlay on any portfolio stock. The premium targeted on positions is flexible and enables us to make adjustments according to prevailing market conditions. The core tenets of our strategies are to identify and own good-quality companies at attractive valuations, with sustainable, resilient income streams and limited downside risk.”
It won’t always be possible to write options on every stock in the portfolio. Kirk says the easiest companies on which to write options are larger-cap, mature businesses, that don’t experience significant volatility – “a Unilever (LSE:ULVR), for example. Something volatile or beaten up, like the housing sector, wouldn’t be the right option.”
The popularity of these funds in today’s environment is counterintuitive. For the first time in a decade, income is abundant. Investors need look no further than the corporate bond market to summon up an income of 6%-7%. However, Kirk believes the current environment gives these funds a clear selling point: “When rates were so low, many people considered 3%-4% from a standard equity income fund to be enough. Reaching for 6%-7% from an enhanced income fund didn’t seem worth it. Unexpectedly, we’ve seen more interest since rates have increased, because the hurdle for standing out as an income fund is higher. If you can get 5% from cash, getting 4%-4.5% from an equity income fund doesn’t look as attractive, but 6%-7% does.”
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He says that investors have also been looking for safety: “An important attribute of these funds is their generally defensive nature – investors reduce their exposure to the upside, but there is more income up front. It’s the bird in the hand argument. In the current markets, trading uncertain future upside for cash in the bank has its appeal.”
Investment trusts also offer a range of strategies to boost the natural yield of a portfolio. They may also employ call-writing strategies, or take income from capital to boost yield. The income-from-capital approach will often be used by high-growth trusts to bring in different types of shareholders. James Carthew, head of investment company research at QuotedData, says: “When income was hard to come by, there was a definite benefit to topping up dividends by paying part of them from capital as trusts as diverse as International Biotechnology (LSE:IBT), Montanaro UK Smaller Companies (LSE:MTU) and JPMorgan Global Growth & Income (LSE:JGGI) do.”
Today, he says, with income more plentiful, the enhanced dividend may be less of a selling point. However, it hasn’t had a significant impact on returns either way, although some investment trusts have had to stop doing it. He points out: “The obvious example of this was Princess Private Equity Ord (LSE:PEY). It had to suspend its dividend payments in the 2008 crash, during the Covid panic in markets and again last year when its currency hedging activities left it severely cash constrained. Each time it did so, the shares took a big knock.”
Creating income by writing options will tend to be used by conventional equity income trusts. Carthew gives the example of the North American Income Trust (LSE:NAIT), managed by abrdn. “The manager has been careful not to lose too much of the upside from NAIT’s portfolio. The option writing augments the naturally attractive level of income generated by the portfolio, allowing the manager to hold some faster-growing but lower-yielding stocks.”
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Sykes is clear about the place of enhanced income strategies in a portfolio. He says: “Relative to a purely high-yield portfolio, the covered call strategy allows ownership of higher-quality companies, thereby increasing the resilience of income generation and reducing downside risk.”
This can make it a good option for education costs, for retirement drawdown portfolios, or even, says Kirk, to help manage day-to-day living costs. He notes: “Some of the demand we see comes from those whose living expenses are higher, trading up from a standard income fund to an enhanced income fund.”
It hasn’t been an easy environment for enhanced income strategies, but they are a good option for investors who want a high, regular income, and are less worried about keeping pace with markets. That said, the current climate of choppier markets may suit them better than the buoyant growth of the recent past. They are certainly having a moment.
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