Although the use of derivatives provides extra income, it comes at a price. Tom Whitelaw provides an overview of derivative equity income funds.
Derivative income strategies attempt to increase income distributions from sharemarket investment by use of derivative instruments.
If a fund manager uses a ‘buy-write’ overlay strategy, for example, the manager caps some of the upside potential of the stocks in the portfolio by the use of call options - in effect, selling some of tomorrow’s possible upside growth on a stock for an income premium today.
This additional income doesn’t come for free - it is paid out of potential future growth. The returns profiles of these strategies therefore differ from traditional long-only share funds.
Derivative income approaches will lag the market in rapidly rising market conditions, given the aforementioned upside cap.
In negative, flat, or slowly-rising markets, however, derivative income strategies should outperform, because of the additional income premiums generated.
These strategies are still at the behest of sharemarkets.
While an investor may be receiving 8 percent in income, if the value of the capital is reducing, that 8 percent is worth less in real money terms.
It’s also important to ensure that the investor is not sacrificing too much growth, or even receiving some income directly from the capital component of their investment.
The day may come when the capital value has been eroded to such an extent that the income it produces is no longer sufficient to meet the original need.
Trading derivatives is a highly-specialised skillset, and requires a different mindset to traditional sharemarket investment.
It’s therefore important that the personnel responsible are suitably experienced. The portfolio manager needs to have a clearly proven ability to trade options, as this drives a proportion of the additional income.
It’s also better if portfolio managers have experience trading options and running money in Australia – although these instruments trade in a similar fashion around the world, each individual market has its own nuances.
This also needs to be undertaken with the bigger picture in mind. Investors are still buying a share portfolio, and on the whole expect it to perform like the underlying benchmark.
For instance, if a fund manager just has one call option written on BHP Billiton at A$40 when the stock is trading at A$37, but the stock rises 10 percent to breach the A$40 mark, the manager is effectively naked in terms of the largest name on the ASX.
This often requires multiple positions to be written around individual names to avoid the portfolio getting unexpectedly called away, and looking markedly different from the index.
Table 1 summarises the performances of three Australian derivative income strategies recently assessed by Morningstar – Colonial First State Equity Income, Merlon Australian Share Income, and Zurich Investments Equity Income – compared to traditional income approaches which do not employ derivatives.
These three funds have provided much higher income than both the S&P/ASX200 Accumulation Index and other income-focused offerings over the last three years.
From a total return standpoint, though, returns have not been as strong.
The negative returns in the five-year growth return column illustrate the point discussed earlier – although the use of derivatives provides extra income, it comes at the expense of capital growth.
This has an even greater impact in rapidly-rising market conditions – during 2012, when the S&P/ASX200 Accumulation Index rose 19.66 per cent, the derivative income strategies lagged significantly from a total return perspective, while traditional dividend and franking credit harvesters outperformed strongly.
The income premium from writing options does however provide smooth returns, and although some of the upside is capped, this premium helps support returns in more difficult market conditions, as the much lower volatility over the past three years shows.
Investors and advisers need to consider all these issues carefully when contemplating investing in a derivative income strategy.
Unlike traditional sources of income, distributions are much more variable.
If the investor takes all the income out of the fund, there’s a danger of capital erosion. An alternative use could be as diversification tools. The use of derivatives changes the return profile.
If an investor was to reinvest distributions, that income component helps diversify the source of return, reducing drawdowns for investors with less risk tolerance while acting as a nice portfolio anchor in more turbulent times.
Tom Whitelaw is the research manager at Morningstar.