On a quarterly basis, UK Equity Income was the best-selling IA sector in three of the six quarters to the second quarter of 2015 (the IA’s most recent quarterly numbers at the time this article was produced) and Targeted Absolute Return in two of the quarters.
Types of income fund
As the name suggests, income funds pay out an income to the investor on a regular basis (for example, monthly, quarterly or half yearly), based on the mandate and performance of the fund and are likely to be managed in one of the following ways:
* Investing in a mixture of equities paying dividends, bonds, property and possibly other income producing asset classes, either directly or through other funds.
The exact mix will depend on the point in the economic and market cycle (for example, government bonds tend to do better at times of economic weakness while commercial property typically does well when the economy expands).
More income funds now hold ‘alternative’ or ‘non-traditional’ assets, such as emerging market debt, high yield bonds and infrastructure in order to gain extra yield as yields on ‘traditional’ government and investment grade corporate bonds remain low, although this can equate to greater risk.
However, this could also lead to a diversification of the income being generated.
* Investing as previously but using derivatives to ‘smooth’ returns.
In this case the fund will seek to sell call options (usually monthly) on the individual positions held in the portfolio.
A call option works such that the buyer pays for the option on the underlying asset.
The buyer then has the right, but not the obligation, to buy that asset at a specified price - the strike price - for a certain period of time.
If the asset fails to meet the strike price before the expiration date then the option expires and becomes worthless.
Investors buy call options when they think the price of the underlying asset will rise and vice versa.
Thus:
If the price of the underlying holding in the fund rises above a certain level (the strike price) then the fund must pay the buyer of the option the price of the security.
If the price of the underlying holding remains below the strike price then the fund does not pay the buyer of the option anything.
In both cases the fund receives the income from selling the call option.
The derivatives will therefore have the effect of ‘topping up’ the fund’s income when the assets fail to produce it naturally but will sacrifice some of the returns when they are greater than a certain level.
These funds will normally have a specific target income yield.
