By John Moore
The equity income sector continues to grow as historically low interest rates globally means investors are hunting for yield. Not all equity income funds are the same and investors should be aware of the equity exposure a fund is taking to generate income. Investors need to consider their objectives and ongoing requirements, as taking on too much risk at the wrong time can prove disastrous.
Any assessment of the equity income space and products should identify traditional equity managers who invest in long-only dividend-builder type funds and generally have up to 100% exposure to equity markets. Generally, these consist of a portfolio of Australian shares that deliver dividend income plus franking credits and capital growth over the long term. Investing in shares for income works best if company dividends are sustained and growing. However, dividend growth isn’t guaranteed in the face of falling profits and dividends alone might not meet an investor’s need for income.
The use of options
It is important for investors who intend to use their shares as sources of income to consider other ways of earning income in addition to dividends and franking credits.
Over the past few years, we have seen the emergence of equity income funds which apply an option or risk overlay to enhance income and reduce the exposure to equity markets. These funds generate additional income by selling call options over the shares held in the portfolio.
The benefits of options are threefold:
- to generate income from option premiums
- to manage the fund’s exposure to the share market
- to reduce volatility and downside risk.
So how does it work in practice? To generate enhanced income, the fund buys a stock and sells a call option over that stock whereby the fund receives:
- any dividend paid during the period
- the option premium
- any franking credits associated with the dividend payment.
Call options 101
A call option gives the holder the right, but not the obligation, to buy a stock at a specified price (known as the strike price) within a specified time period.
- Buying a call option
- When you buy a call option you buy the right to buy the stock at the strike price. You pay a premium for this right.
- Selling a call option
- When you sell a call option you earn a premium. In return for this premium you have the obligation to sell the stock at the strike price if the buyer asks you to.
The following example provides more information on call overwriting strategies:
Starting share price = $100
Strike price = $110
Option premium = $2
If the share price falls, stays the same or rises but stays below the strike price of $110:
- The seller of the call option has earned a premium.
- The call option is worthless to the buyer as they can buy the shares for a lower price on the share market.
If the share price goes above the strike price, say up to $115:
- The buyer of the call option can make a profit (less the premium paid) by buying the shares for the strike price of $110 and then selling them in the market for $115.
- The seller of the call option has earned a premium of $2 and has also made a gain on the shares of $10 (the difference between the strike price and starting share price). However, if the option is exercised they will have to sell the share at the strike price, forgoing the extra $5 per share.
Managing exposure to equity markets
An equity manager that uses call overwriting to enhance income and reduce risk typically has an equity exposure of 60 to 80% of equity markets. The emergence of a new type of equity income fund that incorporates an index hedging strategy in addition to its call overwriting strategy provides an alternative as risk is often further reduced to 50% exposure to equity markets.
A useful way of comparing the risk of differing investment opportunities is to examine how each performs in a stress-testing environment. For instance, if we stress test an equity portfolio for a fall of -10% in the equity market, most equity funds with the same volatility and risk profile of the index and will perform in line with this move downwards.
An asset manager that dramatically reduces this risk through hedging and call overwriting could have outperformed this benchmark significantly (by up to 6.34%). Although investors can’t totally avoid exposure to adverse market conditions (unless 100% invested in cash), a smaller exposure to negative returns avoid erosion of capital and a swifter recovery. Drawdowns are a useful way of comparing funds over time. Avoiding large drawdowns in down markets helps investments recover.
The GFC was a clear reminder that risk is equally important as returns. Recent market shocks like Brexit and doubts about the strength of the global economy (in particular, China) should encourage the conservative investor to focus on risk-adjusted returns. The fact that the VIX volatility index is at its lowest level since 1993 and corporate bond spreads have rallied strongly this year suggests a high degree of complacency has crept into market.
Conservative investing requires a balance between goals: too little risk means savings could be eaten away by inflation and too much risk could result in volatile returns which have the potential to destroy capital. Understand which equity income fund meets your needs.
Content first published on cuffelinks.com.au.