With the current low rate environment in mind, Schroders has identified an opportunity to create an equity-based fund - the Income Maximiser - that should provide a higher income using a unique approach
Trying to generate a high income from investments during times of low inflation, low bond yields and low interest rates can be very difficult. To try and achieve this in the current environment, many funds are investing in very high-yielding stocks, or higher-yielding bonds, which may mean greater risk to investors' portfolios. Equity income funds, on the other hand, have the advantage of giving investors the opportunity to receive a high level of income, generated from stock dividends from more financially sound and stable companies, along with the potential for capital growth.
With this low rate environment in mind, Schroders identified an opportunity to create an equity-based fund that should provide a higher income using a unique approach.
A new approach to income investing
Schroder Income Maximiser is a new fund that aims to generate a high income from the UK stock market. It will use an innovative approach, investing in stocks and selling options with the aim of producing a higher level of income than is possible for a traditional equity income fund.
This actively managed fund will invest in a carefully selected, high quality portfolio of 30 to 40 UK large-cap stocks paying high, sustainable dividends. The stocks in the portfolio will be selected by Nick Purves, manager of the AA-rated Schroder Income fund1.
To enhance the income on the portfolio 'covered call options' will be sold on each of the stocks. The fee (premium) Schroder Income Maximiser receives from selling these options will help to boost the yield of the fund. Of course, the trade off for the extra income is that the potential for capital growth will be restricted.
The options market
What is a call option?
A call option is a contract that gives the option buyer the right, but not the obligation, to buy a share at a fixed price (the strike price) on a specified date in the future. The seller of an option contract charges a fee or a 'premium' for this privilege.
What is a covered call option?
The term 'covered' means that seller of the call option also owns the underlying stock they are selling the call on. Covered calls are sold because the seller prefers to receive a known premium income in exchange for a potential, but uncertain, gain in the stock price. In the case of Schroder Income Maximiser, this 'premium' is used to enhance the yield.
Covered call writing may be considered a more conservative strategy than outright stock ownership, because the seller's downside risk on each stock holding is reduced by the premium he receives from selling the call option.
Whether or not an option is ever exercised, the seller keeps the premium. This strategy allows Schroder Income Maximiser to exchange an uncertain future benefit (any rise in share price above the strike price) for an agreed premium payment.
The development that has made this possible is the growth of a large derivative market that places a value on such uncertain outcomes based on share price volatility.
There is a well developed market for buying and selling options that has been in existence for many years (just as there is for trading stocks) so Schroders should be able to achieve a reasonable premium for selling covered call options, in all normal market conditions.
It is important to note that the pricing of options does not require buyers of covered call options to take a view on market direction. Therefore the extra income will not be driven by the expected direction of the market (ie an expectation of whether this will go up or down) but will be based principally on market expectations of the volatility of the underlying stocks.
The effect of different market conditions
A traditional equity income fund relies on dividends from the stocks it holds to provide a regular income, and also aims for a measure of capital growth as these stock prices rise. Schroder Income Maximiser does the same, but aims to enhance income by the sale of covered call options. This will involve some sacrifice of capital gain if stock prices rise sharply.
Assuming the market is not extremely volatile, the likely performance of Schroder Income Maximiser compared to a traditional equity income fund is summarised below:
In flat markets - Schroder Income Maximiser has the potential to outperform the more traditional UK equity income fund because the stocks are less likely to grow above the strike price set on the options. The fund will receive a higher income, without being penalised in practice from the capped upside.
In rising markets - If rises are dramatic, the fund is more likely to underperform a traditional UK equity income fund because of the effect of the capped capital growth. If rises are more gradual, the fund has the potential to outperform dependent on whether the increases are broadly based or more stock specific.
In declining markets - Schroder Income Maximiser has potential to outperform, because the higher income is less likely to be offset by any effects of capped capital growth.
In volatile markets trading sideways - performance will be driven by more stock specific issues so it is difficult to make generalisations.
The income and growth of the fund as a whole will depend on the performance of the individual holdings.
How the fund is managed
Schroder Income Maximiser will benefit from two layers of specialist management expertise. Fund manager Richard Lloyd will take responsibility for all investment decisions and the day-to-day running of the fund. LLoyd is the head of Schroders' Structured Investments Team and will be in charge of the covered call options strategy. His team manages over £3.5bn of structured investments assets and has 18 years of derivatives and options trading experience. The equity portfolio will be selected by Nick Purves. These stocks will be derived predominantly from the FTSE 100 component of his top-performing Schroder Income fund.
This combination of expertise will ensure the innovative aspects of the fund will be co-ordinated and managed by a proven team of experts, each a specialist in their field.
Schroder Income Maximiser launches on 7 November 2005. There is a two- week offer period from 24 October to 4 November where there is a discount on the initial charge.
For more information please go to www.schroders.co.uk/incomemax or call Schroder Investor Services on 0800 718 777*.
1. The Schroder Income fund is AA rated by Standard & Poor's as at August 2005 and Forsyth-OBSR as at July 2005.
2. The gross yield quoted is an estimate and is not guaranteed.
Important information
For professional advisers only. This material is not suitable for private investors.
Source for funds under management and experience: Schroders as at 30 June 2005. The gross yield quoted is an estimate and is not guaranteed. The fund will make use of derivatives, which can involve a high degree of risk and can be more volatile. This fund should only be considered as a long-term investment. Portfolios which invest in a smaller number of stocks carry more risk than funds spread across a larger number of companies. As the annual management fee of Schroder Income Maximiser is charged to capital, the distributable income of the fund may be higher but the fund's capital value may be eroded which will affect future performance of the fund. *For your security, communications may be taped or monitored. Issued in September 2005 by Schroder Investments Limited, 31 Gresham Street, London EC2V 7QA. Registered No: 2015527. Authorised and regulated by the Financial Services Authority.
