Enhanced income funds seem like a seductive solution to the difficulty of generating income in a low interest rate world. Paying income levels of 5% and higher, these funds have found a ready market with some funds now over £1 billion in size.
However, a recent Hargreaves Lansdown report starkly showed the extent to which investors were sacrificing capital growth for income in some cases.
How Do Enhanced Income Funds Work?
Within these funds, a manager holds a portfolio of shares, adding a layer of market bets with the aim to boost the returns. Usually, this is based on an existing fund – the Schroder Income Maximiser is based on the Schroder Income fund, for example. The manager, or – more usually, a specialist internal derivatives team – will then write options on certain stocks in the portfolio.
These options give the buyer the option to buy the stock at a certain price. If a share was currently trading at 50p and an option is written with a strike price of 60p, the fund manager has to sell those shares to the buyer at 60p.
The buyer would only exercise the option if the shares were higher, say 80p. As a result, the fund manager has missed out on the change in price from 60p to 80p, but he has still made 10p, plus the ‘option premium’ – say 5p – which he can use to boost the income on the fund.
Income in Place of Capital Growth
In a rising market, the opportunity cost of writing these options rises and this, according to the Hargreaves Lansdown report, is what has been happening over the past few years. The RWC Enhanced Income fund, for example, has delivered an impressive £5,649 in income on an investment of £10,000 over the 10 years to the end of 2016, but the capital value of the fund has fallen 21.2%. It is a similar picture with the Insight Equity Income Booster, which has paid an income of £5,463, but lost 24.4% of its capital.
In general, investors would have been better off – on an income, capital and total return basis – with funds paying the highest income, but not writing options. These included the SLI UK Equity Income Unconstrained fund, which gave £4,571 of income, but also a 52.2% uplift in capital, or the JOHCM UK Equity Income fund, which gave income of £4,551 plus a 24.7% capital gain.
The total return for enhanced income funds was towards the lower end of the survey. For the RWC fund, for example, the total return was less than half that of the SLI and JOHCM funds.
Laith Khalaf, senior analyst at Hargreaves Lansdown, said: “Managers will say that they sell options on stocks that they consider to be more highly valued and therefore with less upside, but there is a substitution of income for capital gain. For some investors want jam today and will be happy to have less jam tomorrow, but it is important that they understand they could be eroding their capital base; and if they lose capital, it can be more difficult to generate meaningful income.”
This has been labelled ‘pound-cost ravaging’, where the capital value of an investment becomes depleted. Therefore even if the yield is higher, the income falls over time. If the investor continues to take a higher income, the capital falls further and a negative spiral develops.
Who are Enhanced Income Funds Suitable For?
For investors in the later stages of retirement, who need income, and want to leave a pot behind as an inheritance, this may be appropriate. Equally, for those paying school fees, who may not be worried if there is a large pot left at the end, this may be a good solution. For investors earlier in retirement or who need to preserve capital, however, it is more problematic.
The sector is not homogenous. The Schroder Income Maximiser for example targets an income of 7%, where Fidelity MoneyBuilder Enhanced Income fund, which aims for around 50-100% more than the yield on the Moneybuilder Dividend fund.
Equally, these funds are subject to other variables, such as manager skill, or the efficiency and strength of the options-writing team. They tend only to be offered by larger groups with derivatives expertise in-house.
One little recognised advantage for all enhanced income funds is that they provide some protection against volatile markets. Within the price of every option is an adjustment for volatility – the premium is higher when markets are volatile, lower when they are not. Those who are writing options receive a higher price when market volatility is higher.
Enhanced income funds offer a potential solution to those who need high income upfront, but in recent years investors have been better off, in total return terms, picking a manager delivering a the highest income without using options-writing. That said, the bull markets of the past five years have not flattered this type of fund, and they may thrive again in a climate of greater volatility and lower aggregate market returns.
