7% income funds: Can they be trusted?

Not so long ago it was possible to earn a high and relatively safe return on your cash by parking it in a savings account. Interest rates on savings accounts halfway through 2007 - just before the financial crisis struck - stood at 5.75% or more.

Nowadays, such rates are hard to imagine. The rates on most savings accounts hover around the 1% mark, and the FTSE 100 dividend yield stands at 3.8%.

Research suggests investors still yearn for the heady days of higher interest rates. To cater for this 'desperation' for income, a new type of UK equity income fund has been establishing itself over the past decade and more.

So-called enhanced income or income booster funds, pioneered by Schroders in November 2005, promise yields of around 7%.

Understanding is key

The consensus from investment experts is that these funds, which boost their natural income by writing covered call options on their underlying stocks (see below), are no more risky than 'vanilla' income funds.

However, Tom Becket, chief investment officer at Psigma, wonders how easy it is for retail investors to understand these funds.

He says: "I think the fact that [such funds] have gone through 10 years of [enhancing income] and done it moderately well should tick a box for them," he says.

"They have gone through a full investment cycle and been proven to work. [But] I've found explaining how they work to certain clients quite difficult. I don't necessarily think they're dangerous. But you need to be in a position to explain them properly to retail clients."

John Teahan, equity income manager at the RWC Enhanced Income fund, explains that volatility is a main determinant of option prices. In periods of high stock market volatility, the fund receives either a higher premium for the option or a higher strike price.

However, there is a lack of volatility in financial markets currently, so in Teahan's view, "it is not a great time to write call options". For this reason, the fund's payout to investors has been reduced from 7% to 6.5% over the past four months.

"At the moment it's prudent not to stretch for that extreme income; it's more sensible to allow the stocks to gain any upside they have. That has benefited us because the market has been quite strong," he says.

The fund is currently carrying 20% in cash. "[So] when volatility picks up again, we'll go in very quickly and take advantage of that," he adds.

Rupert Rucker, client portfolio manager at Schroders, says there is a misconception that writing options adds risk to portfolios. "Actually, when you write calls, you're selling risk and receiving an income for that trade," he says.

Chris Wright, manager of the Premier Optimum Income fund, agrees. He explains that by using options, funds transfer risk into steadier income.

Look for top stockpickers

Becket says the derivatives overlay is not too complicated, but he adds that risks can arise when investors ignore the capabilities of a fund manager and focus overly on the covered call option strategy.

He points out the importance of picking a manager who is good at buying equity investments: "If you buy a poor equity investor on the basis of his covered call strategy, that can count against you."

Kevin Murphy and Nick Kirrage, managers of the Schroder Income and Schroder Income Maximiser funds, are "excellent value investors", he adds.

Becket also holds the RWC fund, managed by the original Schroder Income Maximiser team, in high regard, as "it takes a pragmatic approach to deciding which companies are worth having covered calls written on them".

Should you own these funds? For long-term investors the merits are limited, due to the potential for investors to lose capital.

In performance terms, the average five-year total return for the five straightforward income funds in our table is £20,407, 27.5% more than the average for the enhanced income funds.

Ben Yearsley, investment director at Wealth Club, says that if investors are patient and take a long-term view, the yield from conventional income funds should catch up with that from enhanced income offerings, as it is difficult for the latter to grow their income payouts.

He adds: "While the starting income [on an enhanced income fund] looks great - at maybe 6%, compared with 4% on a normal fund - if the capital doesn't keep pace, it's harder for the income to grow.

If both funds start at £10,000, and by the 10th year the normal fund is worth £20,000 and the enhanced fund only worth £13,000, and both are still paying the same percentage yield they did at the start, the enhanced income fund will pay £780 this year and the normal fund £800.

The income stream will grow quicker in the normal fund, as its capital base should grow quicker.

In fact over 10 years, with a starting value of £10,000 and income reinvested, the Schroder Income fund has turned into £22,700, compared with £19,800 for the Schroder Income Maximiser. That gap will only get bigger."

Complex decision

Becket also questions the wisdom of picking the Income Maximiser fund over the Income fund, especially if you believe managers are capable of finding long-term winning companies that are underpriced by the market and can deliver considerable upside or become bid takeovers.

"Take some of the bids we've seen recently, such as Booker Group or ARM Holdings," he says.

If you'd had a covered call option overlay strategy over those companies, you would have limited your upside to around 10%, rather than the 15-25% extra premium you'd have got when the bid took place, so there are some limitations in the mergers and acquisitions environment we're seeing now.

Also company share prices are responding very well to good results and very badly to poor results. If you think you're buying a strategy on the basis of a fund manager's stockpicking ability and want them to find lots of winners, you could be pricing yourself out of some of the upside of these specific strategies."

Jason Hollands, managing director at Tilney Group, says the strategy is most useful for those with an immediate need to maximise their income, those who are retired and perhaps in pension drawdown, for example.

However, he cautions that these funds should not be seen as 'magic bullets', as "you are swapping some future growth for some immediate income, so these are very much about rearranging a return profile, rather than creating new value".

Brian Dennehy, managing director at FundExpert.co.uk, observes that moving from pension pot accumulation to drawdown requires investors to think differently. While capital growth is important initially, once you need income, your focus must be on income generation.

He says: "At this point the capital no longer has value measured in terms of how much it grows - at least not as a priority," he says.

"The primary value of the capital now lies in its ability to generate the income you desire. If someone wants the higher income from a maximiser fund, the proper perspective is not that they aren't giving up capital growth, but rather that they are giving up future income growth."

For those who need immediate and stable income, enhanced income funds have delivered this over a long period. However, it is important that investors understand they will miss out on a potentially large chunk of capital growth if they go down the enhanced income route.

Enhanced income funds explained

With enhanced income funds, the underlying portfolios are generally made up of companies listed on blue-chip indices, and they usually mirror a conventional equity income fund and are managed by the same team.

In order to offer a yield higher than the 3.8% FTSE 100 average annual return, an enhanced income fund manager sells option contracts on the stock in his portfolio.

Option contracts give a buyer - another professional investor - a right, but not an obligation, to buy shares at a fixed 'strike' price on a specified future date. In return, the fund receives a 'premium' (fee), which it then distributes to investors to boost income payments.

Should the share price fail to reach the strike price before the exercise date expires, the buyer won't exercise their option.

However, should the share price rise above the strike price, the fund must sell the buyer its shares at the agreed - lower - price. This means the fund loses out on capital growth in order to secure upfront income.

Writing 'naked' call options (selling options without owning the stock) can entail unlimited losses, as the share price can rise infinitely. Covered calls hedge that risk by owning the stock in question so that the call writer also gains from the rise in the share price.

Ben Yearsley says enhanced income funds should outperform in static or falling markets, but they can get left behind in rising markets. "BT today is currently 330p a share," he explains.

"You might sell a call that gives someone the right to buy them for £4 in a year's time. As the writer of the call, the enhanced income fund gets paid [a premium, typically of 2-3%].

If the price doesn't hit £4, the call doesn't get exercised, and the enhanced fund gains 2-3% compared with the normal fund. But if BT reaches £5, the normal income fund has made an extra £1 profit, as the enhanced fund is forced to sell at £4 to the buyer of the call option."

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.