The nuts and bolts of enhanced income funds
17th August 2015 13:55
by Chris Wright from ii contributor
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UK equity income funds have long been very popular as a home for UK investors looking for long-term income and growth. The combination of high dividend payments, with some dividend and capital growth has been a natural attraction.
In the UK funds industry, funds in the main UK equity income sector are required to have an annual yield that is 10% higher than the FTSE All-Share Index over a three-year period. The FTSE All-Share Index represents the performance of 98% of the UK's market capitalisation and as at 31 July 2015 the dividend yield of this index was 3.39%.
UK equity income funds invest principally in the UK market, typically in shares of our largest companies, and pay out natural income in the form of dividends from these companies that are passed on to the funds' investors.
Successful strategy
For a very long time, this has been a successful strategy. Banking, utility, oil, mining, telecommunications, food retailing companies and of course tobacco shares, have been consistent constituents of income funds for many years. And these had proved to be a stable provider of long-term dividend income for investors.
However, the financial crisis of 2008 started to put dividends from many companies under strain. Dividend cuts from banks including , and during 2009 hurt the dividend accounts of many UK equity income funds.
In other sectors, income-paying stalwarts such as and , in supposedly "safe" areas of the market, also both cut their dividends that year.
Finally, as if to add insult to injury, then followed in 2010. and joined the dividend cutting list in 2014 and 2015 respectively. Natural dividend income as a concept has had a rough few years. The question is: will it get better?
Nearly 47% of the dividend yield from the FTSE All-Share Index is accounted for by just 10 dividend-paying stocks: , HSBC, BP, , , , , , and .
Some of these companies are experiencing pressure on their profits that will potentially make it harder for them to increase or even retain current dividend levels.
For example, a fall in commodity prices is making life more difficult for oil and mineral companies who are typically dependent on constraint of supply and an acceleration in world GDP growth for their own prosperity. We can't be confident of either of these working in favour of these companies in the near term.
Out of the top 10 income contributors, the four oil and mineral companies will have their lowest dividend cover, which is the ratio of a company's net profits to the total in dividends paid to ordinary shareholders, for over 15 years in 2015. In the absence of any vigorous bounce back in profits, some dividends may be at risk over the next year or so.
Other larger dividend-paying companies are also balancing paying out dividends either not covered or just covered by earnings, with high debts and high capital expenditure as they invest for future growth.
We believe UK shares continue to offer attractive investment opportunities for long-term income investors, but the near-term challenges for dividend-paying companies are also clear to see, which may have an impact on the prospects for rising income payments for investors.
Options
One way income investors can potentially boost their income from a UK equity fund is by investing in a fund designed to enhance the natural income paid by UK companies, by adopting an additional investment strategy, typically by dealing in a specific type of financial contract called an option.
An option is a type of contract that offers the buyer the right, but not the obligation, to buy or sell a stock or other financial asset at an agreed-upon price during a certain period of time or on a specific date. If dividends don't grow, inflation will erode the real value of the income, but enhanced income funds can offer some head room to help if this happens.
For a UK equity income fund manager using options to enhance income for investors, we believe the five key drivers in determining the price and value of any option contract are: time to expiry, interest rates, expected dividend, strike price, and implied (expected) volatility.
The higher the expected volatility in the equity market, the better price we expect to get for our option. What tends to happen is that if we get dividend cuts in large companies, the volatility of that share increases, which results in higher prices for the options we sell on behalf of the fund. This is good news for the funds' investors and should help compensate for the cut in dividend payment.
This type of enhanced income strategy can significantly improve the level of income paid to investors compared with the natural dividend yield from the stockmarket. Using option contracts can also boost the capital return of a fund if stocks fall or gently rise, but may cause the fund's performance to lag a strongly rising market.
Chris Wright is manager of the and the , winner of the Money Observer 2015 Fund Award for Best Ethical/SRI Equity Fund.
This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.