Options pay dividends

I love dividends. Luckily, it is not only fund managers like me that love dividend income. Financial advisers and their clients also seem to appreciate the qualities of equity income funds and with good reason.

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.

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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.