Recent years have seen the emergence of a new breed of equity income funds. Known as covered call funds, they distinguish themselves by offering unusually high yields – often 7-8% compared to the 3-5% available on typical UK equity income funds. Schroder Income Maximiser became the UK’s first covered call fund at the end of 2005 and, following its success, last year saw the arrival of rival offerings Fidelity Enhanced Income and Insight UK Equity Income Booster. Recent months have seen the launch of international covered call funds Schroder Asian Income Maximiser and Ignis Argonaut European Enhanced Income.
At their core all of these funds are equity income funds, investing in high yielding, generally larger cap stocks. Where they differ is through the use of covered calls.
What is a covered call?
The covered call strategy involves a call option, a type of derivative which gives the holder the right to buy a share at a fixed price.
The fund managers sell call options on the stocks in their portfolio (the term covered call indicates that the fund owns the stock in question). This restricts potential growth in each stock to the level the option is set at, typically 10% or so a quarter. However, the money received for the options (the premium) can be paid out as income, increasing the fund’s yield.
Essentially the fund manager is sacrificing some potential capital growth in exchange for a boost to the fund’s yield. This boost can be significant – Schroder Income Maximiser has consistently met its 7% yield target whereas Schroder Income, run by the same managers, is currently yielding 3.2%.
Performance characteristics
We expect covered call funds to perform best in falling or level markets, but to underperform in strongly rising markets – any additional upside in the quarter beyond the level of the options is lost. Since launch the performance of Schroder Income Maximiser has been similar in total return terms to Schroder Income – holders have received more income but less capital growth.
Bestinvest’s view
With the overall performance of covered call funds likely to be similar to regular income funds we suggest investors only use them where they have confidence in the managers – in some cases higher yields may come at the expense of lower total returns. Investors should remember that there are other ways of achieving an income from a portfolio – for instance, Cofunds and FundsNetwork offer capital withdrawal facilities. Covered call funds are a useful weapon in an investor’s armoury, but you should be wary of chasing income at the expense of the overall health of your portfolio.
Our current choices
If there is anything you wish to discuss regarding this article please call one of our Advisers on 020 7189 9999.
This article is intended as a summary of our research into covered call funds, not as a personal recommendation or advice. If you do require advice on whether this fund is suitable for you then please contact us or your adviser.