As yields on bonds and stocks continue to decline, investors are looking for other ways to earn a higher income without taking added risk. One approach that may sound tempting involves “enhanced income funds”. These are able to pay out higher-than-average dividends (up to 8% or 9% in some cases) to investors by giving up some of the potential capital gains on the shares they hold, using a derivatives strategy called “covered call writing”. In effect, they are converting capital gains into income.
This isn’t as complicated as it sounds. Essentially, the fund sells an “option”, which gives a buyer the right (but not the obligation) to buy a stock from the fund at a prearranged price (known as the strike price) on a specified future date. For this, they receive a payment, known as a premium. If the stock ends up being worth less than the strike price, the fund simply keeps the premium (which it can use to help fund a higher payout to investors).
If the stock ends up being worth more than the strike price, the fund still keeps the premium but must pay the buyer the difference between the actual price of the share and the strike price. However, the fact that the fund holds the stock, which has risen in value, should compensate it for the extra payment that it must make to the buyer.
Thus these funds ultimately involve a trade-off for investors. They receive a dividend that is hopefully higher than that available in the market, but have effectively handed over some of their potential capital gains.
Critics of enhanced income funds say they are too complicated for many retail investors to understand. It’s certainly worth bearing in mind that the managers of funds such as these may lean towards higher-yielding equities where there’s a greater risk of dividend cuts in tough times.
That said, enhanced income funds are typically less volatile than standard income funds in normal markets, as they have a higher yield to fall back on. However, if markets shoot up, the growth that investors miss out on may be greater than the added income they get through selling options.
Thus enhanced income funds are only suitable for those who need to prioritise income over growth. And it is extremely important to make sure you understand the risks of specialist funds such as theseand think carefully about how much of your portfolio you should prudently allocate to them. However, for some investors, funds such as the Schroder Income Maximiser fund, which targets a yield of 7% per year and has delivered around 9% over the past 12 months, could be worth a look.