February 9, 2007 5:29 pm

Covered Call Funds

What do you do when, following strong rises in stock markets, decent yields from UK equities are getting harder to come by? Some investors might consider fixed-interest products, such as corporate bonds, where yields are higher, even if the potential for capital gains are much less.

But in the US there is another way and this alternative is slowly gaining traction in the UK. Growing numbers of investors can put their money into covered call funds which use derivatives on top of traditional equities to generate above-average income yields.

Billions of dollars have been invested in these funds in the US. In the past couple of years a number of UK fund managers have started using covered call strategies and there is even one fund aimed at private investors.

So what is a covered call fund?

Covered call funds are not terribly complicated products. Neither are they the most exciting. But they can generate an above-average yield, although the cost is usually less generous capital growth.

A fund which uses covered call options holds shares in companies in the same way as any other equity fund. The difference, and how it earns additional income, is that it sells options against those shares rising above a certain price. These are call options.

By selling a call option a fund manager is agreeing to forsake some future growth on a particular share. In return, the fund manager receives a small fee which he can pass on to the fund’s investors to beef up the fund’s income yield.

Covered call funds aim to offer yields of up to 7 per cent, which compares very favourably with the current dividend yield on the FTSE 100 of just under 2.9 per cent. The higher yield from a covered call fund accounts for the dividend yield with the option premium added on top. This means they are aiming to exceed the yields of cash and fixed-income bonds.

Typically a fund will invest in a large company and then sell away some of the potential upside. Any growth in the share above the stated amount will go to the buyer, who pays a premium for this right. So in strongly rising markets, a covered call fund is likely to underperform. But in static and sometimes even moderately rising markets returns can be superior to mainstream equity funds.

To understand what an investor gets out of a covered call fund, imagine a fund buys shares in a large company at 100p each and sells a covered call option on them, stating that any growth in the share above 110p over a specific period, say three months, goes to the buyer, who gives the fund a 4p premium for this. Investors in the fund would receive the dividends from the shares bought by the fund, as well as the premium. So, assuming the dividend payment was 3p, they would be getting 7p while investors in traditional equity funds who had bought the same shares would receive 3p. And as long as the shares do not exceed 110p, they are not forsaking any capital growth.

What happens when markets go down or up sharply?

Once the option price kicks in, investors no longer benefit from the growth of shares held by their fund. This means that they lose out in quickly rising markets and if the market falls, they have no protection, though they would lose only as much as they would through a conventional equity fund.

The worst-case scenario is that markets fall quickly and then go up again quickly. If the growth after the fall exceeds the option limit then the only one who would fully benefit from the recovery is the holder of the option.

What is the benefit of a covered call strategy?

Covered call option funds tend to do best in flat markets, when they can provide a reliable source of income and little or no growth is lost by the fund’s investors. The additional income from dividends means that they can generate more income than straightforward equity income funds. These funds are aimed at investors who want an above-average level of income from their investments and do not mind taking moderate risks.

Why haven’t I heard of them before?

This is partly because the US is often one step ahead of the UK in financial concepts. Mick Gilligan, director of fund research at Killick & Co, says there is not the same history of fund managers using derivatives in the UK as there is in the US. “In order for a UK covered call fund to have credibility it would need to be under fund management with a strong derivatives team,” he says.

Can I invest in them in the UK?

The only open-ended covered call option fund in the UK is the Schroder Income Maximiser, launched in November 2005. The fund aims to provide annual income of 7 per cent and can be invested in as part of an Isa or unit trust. You must put in a minimum of £1,000 as a lump sum or £50 monthly. The initial charge on the fund is 5.25 per cent and the annual charge is 1.5 per cent. The fund returned 16 per cent last year. There is also a closed-end fund from BNP Paribas, which was listed in November 2005 on the Channel Islands stock exchange and returned 10 per cent last year.

Last year was considered ideal for covered call funds, say analysts. Markets rose but not excessively so the Schroder Income Maximiser fund benefited from that. Obviously not every year will be so benign.

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