Options pay dividends

Long-term stock market returns are driven by dividends, and dividends from company shares offer attractive yields compared to other sources of income such as cash and bonds. They can also grow over time, which is important for income investors who have to contend with the impact of inflation.

But there is still the potential danger for income investors that dividend yields go down, do not grow, or do not grow as expected.

One way income investors can potentially boost their income from a UK equity fund and create some head room to help if dividend yields come under pressure is by investing in a UK equity fund that enhances the natural income paid by companies in the form of dividend yields, and by adopting an additional investment strategy for extra income, typically, by dealing in a specific type of financial contract called an option.

So, enhanced equity income funds offer two income sources.

The fund’s first source of income is natural income from holding company shares. UK equity income funds invest principally in the UK market and pay out natural income in the form of dividends from these companies that are passed on to the funds’ investors.

Funds in the IA UK Equity Income sector are required to have an annual yield that is 10 per cent higher than the FTSE All-Share Index over a three-year period. The FTSE All-Share Index represents the performance of 98 per cent of the UK’s market capitalisation, and as at 31 July 2015 the (natural) dividend yield of this index was 3.39 per cent.

A second source of income is from options contracts. This provided an additional 1.7 per cent of income to make a total dividend yield of 6.4 per cent.

For a UK equity income fund manager using options to enhance income for investors, we believe the key drivers in determining the price and value of any option contract are: time to expiry, interest rates, expected dividend, strike price, and implied (expected) volatility.

The strategy is straightforward. Managers sell call options against the shares in individual companies within the fund and the premium received is taken into the fund’s income account to boost the yield for investors.

The higher the expected volatility in the equity market, the better price managers expect to get for the option. What tends to happen is that if a company cuts its dividend payment, the volatility of that share increases, which results in higher prices for the options sold on behalf of the fund. This is good news for the funds’ investors and should help compensate for the cut in dividend payment.

This type of enhanced income strategy can significantly improve the level of income paid to investors compared with the natural dividend yield from the stock market. Using option contracts can also boost the capital return of a fund if stocks fall or gently rise, but may cause the fund’s performance to lag a strongly rising market.

One of the concerns for advisers and their clients about investing in an enhanced income fund using options may be the perceived risks involved in using these financial contracts. The way options are used within some funds mean that the risks are limited and quantifiable. No matter whether the price of the underlying share – and therefore option – moves up, down or sideways, the outcome is predictable. It will be income-enhancing and will help protect capital. It should also be noted that the fund’s holding in shares and options can be sold at any time.

Here is a very brief and broad illustration of how this enhanced income strategy can work:

 The fund buys a share at 100p.

 The fund writes (sells) a call option giving someone the right to buy that stock from the manager at 110p (the strike level) within the next three months

 For that right the buyer will pay the fund a premium of, let us say, 1 per cent of the value of the share price, so in this example, 1p.

 The fund receives this ‘premium’ as extra income that is paid to investors as part of their dividend for shares in the fund.

Scenario 1: if at the end of the three months the stock is below 110p, the fund will gain or lose from the rise or fall in the share price – as it would have done without the options strategy – and receive an extra 1p of income for investors.

Scenario 2: if at the end of the three-month period the stock is above 110p, the fund has benefitted from the growth in the share price up to the strike level (110p) and an extra 1p of dividend for each share. Any gain in value over 110p will accrue to the benefit of the option buyer.

The overall contribution to income paid to investors from this strategy can be meaningful. For example, the dividend yield for the Premier Optimum Income Fund is 6.4 per cent a year. This is made up of a natural dividend yield from company shares of 4.7 per cent a year (versus the FTSE All-Share Index dividend yield of 3.39 per cent a year) and an enhanced dividend yield of 1.7 per cent from the options strategy. Figures as at 31 July 2015.

Option pricing tends to be independent of market direction, but pricing tends to be more attractive for sellers of options, including the Premier Optimum Income Fund, in more volatile markets.

Chris Wright is manager of the Premier Optimum Income Fund

Key points

 Financial advisers and their clients appreciate the qualities of equity income funds.

 Enhanced equity income funds offer two income sources.

 Enhanced income strategy can improve the level of income paid to investors compared with the natural dividend.