EquitiesMar 31 2016

Fidelity uses call options to weather pharma sell-off

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Fidelity uses call options to weather pharma sell-off

The £135m fund uses the same stock selection as Dan Roberts’ £309m Global Dividend fund, but sees co-manager David Jehan implement call option overlays to boost income.

The Enhanced Income fund sells call options against stocks it believes are less likely to rise sharply, and collects the premiums.

Call options allow the manager to agree a fixed price for its holdings with a third party, who pays the fund a premium for the agreement and, should the shares fall below the price, the call option remains unexercised with the fund retaining the premium and the shares. However, the fund can also end up selling its shares below their value.

Mr Jehan said: “Volatility can provide opportunities, so our options went up. [In volatile times] we can increase our activity and generate [extra] income.”

Around half of the fund’s equity exposure is overwritten with call options. Mr Jehan said the fund sold call options on stock favourites he thought were nearing full value. Options on the pharmaceutical sector had benefited the fund’s income recently as the sector plummeted in early 2016. These have now been replaced with options on consumer staples and tobacco.

The MSCI World Pharmaceutical index was down 9.2 per cent by February 11, with the fund retaining the majority of the premiums that were sold against stocks in the portfolio, such as Roche and Johnson & Johnson.

Key numbers

5.8% - Fall in MSCI World Pharmaceutical index year to date

3% - Enhanced Income fund’s exposure to Swiss healthcare firm Roche

Mr Jehan said the 3 per cent exposure to Roche was fully covered with call options but its largest exposure, a 4.7 per cent holding in Johnson & Johnson was only half covered: “We go for the low-hanging fruit, because it’s one of our biggest holdings we don’t generate as much income by selling calls against our largest stocks, it is better to keep it half covered.”

He added: “The fund has not had such a positive [performance] contribution from [pharmaceutical] stocks but [the call options] buffered the lack of performance. In over-writing, it has been a good sector for us.”

However, Mr Jehan said that now the sector had fallen and was moving towards cheap territory, the number of call options would be reduced. He said pharmaceutical stocks stood a “reasonable chance of a rotation”.

The fund’s second biggest, British American Tobacco, is also fully covered. Mr Jehan said the stock, along with Reynolds American, was nearing all-time highs, so he was happier generating income in the short-term via the call premium.

Elsewhere, the fund sold calls against technology stocks, such as Microsoft, over the past three months. The manager said the stock has not been a top performer, meaning the fund has kept all the income generated by the move.

The fund has returned 33 per cent since launch in October 2013 compared to a 17 per cent average return from the IA Global Equity Income sector, according to FE Analytics.