There is a type of equity fund that is hugely popular in the US but has yet to take off in a big way in the UK. Known as a covered call fund, it combines traditional equity investments with derivatives to generate higher levels of income.

A number of UK fund managers are launching such funds over here and more are likely to be launched as fund management groups look for new ways to try to give investors income that exceeds the 3 to 4 per cent yields typical on conventional equity income funds.

“What happens in America tends to come over here,” says Andy Gadd, head of research at Lighthouse Group, the independent financial adviser. “They’ve got $20bn in covered call funds, and that suggests they are going to grow over here.”

These funds are aimed at investors who want a high income from their investments and have a moderate risk tolerance. More and more funds of this type are coming to the market as fund managers take advantage of European Union rules known as Ucits III, which give managers greater freedom to use derivatives in their funds.

Some of these new covered call funds are targeting yields of 7 per cent or more. In these funds, managers typically make two separate trades.

First, the fund manager selects a stock he thinks is worth buying. Second, having bought the stock, he writes and sells a call option on it. This gives the buyer of the option the right, but not the obligation, to buy the stock at a fixed price on a certain date.

Say a fund manager holds shares in fictional bank Megabank, trading at 100p on January 1. He sells a call option that allows someone else to buy Megabank shares off him for 110p on March 30, and receives 1p a share for this option. On March 30, if Megabank shares are below 110p the option expires, giving the fund manager a profit of 1p per share. If they have risen to, say, 115p, the fund manager must sell them at 110p. He will still get his 1p but will give up 5p in gains.

This highlights the risks of these funds. In periods of strong stock market performance, returns may lag behind the wider market. But in flat or moderately rising markets, they should perform broadly in line with the stock market with the added bonus that investors will receive an income kicker from the sale of call options.

The idea is that, by selling call options on key holdings every quarter, a fund manager can generate a yield on the portfolio several percentage points higher than the dividend yield extracted from the underlying stocks.

One such fund that adopts this strategy is the Schroders Income Maximiser Fund managed by Richard Lloyd together with Nick Purves. This fund aims to generate a yield of 7 per cent for investors, of which half comes from dividends and the other half from call options. This is some way higher than the current dividend yield of the FTSE 100 of just under 3 per cent.

Launched in November 2005, the fund looks set to beat its income target in its first year (see table). But if the stock market falls, this fund is likely to follow the market down.

“We have always marketed it to investors as not having capital protection,” says Lloyd. “It’s an equity fund with a higher income level and a bit less volatility.”

The range of UK stocks the fund can invest in is limited – they must generate a decent dividend yield, and the market for call options is restricted to large companies. This type of fund tends to outperform conventional equity funds when markets are falling or drifting slowly upwards, but lags behind when markets are booming.  

The use of derivatives may put off some investors. Garry Topp, a director at Nomura, says: “The challenge is to find a way a product can be created that produces a high income without baffling the consumer . . . There’s a lot of rocket science involved. The interesting thing will be the extent to which IFAs take covered call strategies to their hearts.”

Gadd at Lighthouse Group is enthusiastic about covered call funds. “They are an excellent way to generate income,” he says.

“I’d say ‘don’t put all your eggs in one basket’, but they are good as part of a portfolio.”

Other funds offer variations. Morley Fund Management offers a Global Balanced Income Fund that invests 60 per cent of its assets in covered call strategies and 40 per cent in convertible bonds, which can be turned into shares. The convertible bond strategy should give investors a higher income stream, yet with some equity upside if the underlying shares perform well.

Tom Wills, one of the fund’s managers, highlights the fact that it can invest in a range of 500 large companies worldwide. He says: “It’s a global fund. I don’t think it makes sense to do it just in the UK. You would restrict yourself.”

Morley offers a similar, but more cautious, fund that invests 40 per cent in equities and 60 per cent in bonds.

Royal London Asset Management is to launch a bond fund that it says will “employ full Ucits III powers” by using derivatives and giving investors high quarterly payments and capital growth.

The F&C High Income Fund has been using a combination of stocks, bonds and derivatives for more than a decade. However, it does not use Ucits III powers to do this but instead invests in loan notes, bond-like assets that contain a derivative element.

Topp at Nomura expects more covered call funds to be launched: “The basic truth you can’t ignore is that there’s an ageing population.

“For levels of income beyond base rates, covered call-writing strategies are the latest thing to move into the spotlight.”