Interactive Investor

Broaden your income horizons to reduce dividend risk

25th May 2016 13:37

Chris Wright from ii contributor

Income remains one of the hot topics of the investment world, and the quest to find a reliable income stream has seen investors look to the UK equity income sector due to its combination of high dividend payments and capital and dividend growth.

Even in this one sector, there are a number of different ways to source a good income stream.

One is to adopt a multi-cap investment approach, taking advantage of good investment opportunities in UK larger-, mid-, and smaller-cap companies. It means investors have more flexibility to avoid companies or sectors where dividends could come under pressure, and to find better income investment opportunities.

For example, when considering mega-cap stocks, with a market capitalisation of around £20 billion, income investors are quite limited in their options when searching for companies that have a good and growing dividend yield.

The multi-cap approach

There are stocks such as BP, Shell and BHP Billiton, but they are all heavily dependent on emerging economies, as well as factors they cannot control such as oil and other commodity prices.

Investors may find many income opportunities in mid-cap stocks, as the cash generation and growth prospects of those companies just outside the larger end of the cap scale, as well as some of their potential for general economic resilience, mean they can be attractive options.

These mid-cap companies are still big businesses: they are often well-financed and growing companies.

Indeed, the mid-cap indices often outperform the larger-cap index, illustrating the fact that there are very good options in the mid caps that could be married well with those in the mega caps in a multi-cap approach.

Stocks of this type that we hold include property developer Berkeley Group. Since the company came to market in the late 1980s, the total return with dividends reinvested has been very strong and the forecast dividend yield is significantly higher than the average dividend return from the FTSE All-Share index.

With forward sales over the next three years due to deliver significant cash, we are optimistic about income prospects.

Likewise, there are many potential small-cap opportunities for income investors. For example, the fund is a long-term holder of Connect Group, a distributor of newspapers, magazines, and books, which despite trading on a very low rating has significantly outperformed the FTSE All-Share and generated a very strong yield.

The enhanced income option

Another potential way for income investors to broaden their income investment potential is to utilise an enhanced income strategy, where a fund uses a financial instrument known as options to be able to pay an additional "distribution" to investors over and above the dividend distributions declared by the different companies in a fund's portfolio.

This type of strategy can be used as part of a multi-cap portfolio approach.

Writing call options is the process whereby an investor purchases a stock and then writes (sells) an option, giving someone the right to buy that stock at a certain price within a certain timeframe.

In exchange for that right, the purchaser will pay the seller a percentage premium of the value of the share price.

While only five funds in the Investment Association's UK equity income sector employ this strategy, they are the five highest-yielding funds in the sector. Premier Optimum Income fund is one, with a historical yield of 7.5% as at 5 May 2016.

In addition to paying an enhanced income, an options strategy in which income is reinvested can also boost the total return of a fund. In a falling or gently rising market, an options strategy would be expected to improve a fund's performance, but it may cause the fund's performance to lag in a strongly rising market.

However, these enhanced income funds do not have to follow options strategies.

Premier Optimum Income fund has typically been invested in about 50-60 dividend paying company shares, and an estimated two thirds to three quarters of the income has been made up of normal dividend distributions, with the rest being made up by options premiums.

As with all types of investment, there are no guarantees on the returns or the income generated, but thinking outside the box can lead to real income rewards for investors.

Chris Wright is manager of Premier Optimum Income fund.

This article was originally published by our sister magazine Money Observer here.

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.