Say "derivatives" and many people imagine an incomprehensible contract designed by an over-educated banker to steal unsophisticated people’s money.
Derivatives can, however, be relatively simple tools that fund managers can use to boost a portfolio with a minimal amount of additional risk.
They are particularly useful for income funds, where a few highly regarded managers have been using them to provide higher payouts to investors.
The funds:
Fidelity Enhanced Income
Schroder Income Maximiser
Fidelity Enhanced Income and Schroder Income Maximiser are among the funds with the very highest yields in the IMA UK Equity Income sector, which they have only managed to achieve thanks to the use of derivatives.
Neither fund appears on the list of the 20 most popular over the past year, despite their high payouts.
Fidelity Enhanced Income, a £108m portfolio in the IMA UK Equity Income sector, is one fund to use such a strategy.
It is yielding the third-highest amount out of the 99 funds in the sector, at 7.08 per cent.
The fund has five FE Crowns and was recently commended by FE’s head of research Rob Gleeson.
Michael Clark (pictured) is in charge of the stock selection, while David Jehan runs the derivatives strategy, boosting the income by writing call options.
In simple English, this means that he signs a contract that gives other investors the right to buy the fund’s shares at a pre-determined price in the future. They pay the fund a non-refundable fee for agreeing to this deal.
If the price of the stock climbs higher than the price that has been agreed, the investor can buy the stock from Fidelity Enhanced Income for less than it costs in the market and sell it on at a profit.
If it does not rise any higher than the agreed price then there is no benefit to buying the stock; instead the fund keeps it and pockets the fee, paying this out to investors in the form of a yield.
The risks to the fund managers are relatively low: they may have to sell some of their stock which they would have preferred to keep, but they can reinvest the money they receive for it.
The managers can pick and choose which stocks they submit to these contracts, and at what price, meaning that they can keep a tight control over how much money is being risked at any one time.
AWD Chase de Vere’s Patrick Connolly (pictured) says that there is little to be frightened of with such a strategy.
"It does add extra risk but it is a controlled risk and from our perspective it’s a more understandable risk than many other types of investment that use derivatives," he said.
"It’s only used on a small part of the portfolio and the risk is spread over a number of stocks."
If the price at which the managers agree to sell any stock – the strike price – is always higher than the price they originally bought the stock for then there is no reason for them to ever lose money on any one investment.
The "risk" is rather that of not achieving all the gains in stock price that they would have done if they could have held onto the shares and sold them at a higher price.
"They are only giving up some of the potential upside to the portfolio," Connolly said.
"Plus, if they believe the stock is very likely to do well then they are unlikely to write the options on the stocks in the first place."
"This means investors have to accept that if markets do well, this type of fund may well get left behind because they are giving up the extra growth potential. We would only use this type of fund for investors looking for extra income."
Data from FE Analytics shows that Fidelity Enhanced Income has performed roughly in line with the average IMA UK Equity Income fund on a total return basis: over the past three years it has made 35.4 per cent while the sector is up 38.71 per cent.
The equity holdings of the portfolio are very similar to those of Clark’s Fidelity Moneybuilder Dividend, which does not have the overlay of derivatives.
Performance of funds vs sector over 3yrs
Source: FE Analytics
Fidelity Moneybuilder Dividend has outperformed its sister fund over three years, according to FE Analytics data, returning 43.54 per cent.
Of the funds that use this strategy, Connolly prefers Schroder Income Maximiser, managed by Thomas See since April 2009.
It has also slightly underperformed the sector in capital return terms over the past three years, although the £828.4m fund is currently yielding 6.53 per cent.
See also runs Schroder Asian Income Maximiser along with Richard Sennitt. This £170.1m portfolio, launched in July 2010, is currently paying out 6.67 per cent.
This is significantly more than the 5.4 per cent paid out by the second-highest yielder in the sector – Henderson Asian Dividend Income.
Schroder Asian Income Maximiser has returned 39.04 per cent since launch, more than the 28.62 per cent from the MSCI Asia Pacific ex Japan index and putting it in the top quartile of its IMA AC Asia Pacific ex Japan sector.
Performance of fund vs sector and index since launch
Source: FE Analytics
Connolly says AWD Chase de Vere uses both Schroders funds, as well as the Fidelity one, in its portfolios for income-seeking investors.
He says that the search for income is likely to see this type of product grow in popularity.
"You are already starting to see other funds following this strategy. Right now it’s a market which Schroders has a strong stranglehold on and one that could be open to new entrants," he said.
The £828.4m Schroder Income Maximiser dwarfs the Fidelity fund as well as the £25.8m Insight UK Equity Income Booster and the £8.8m Ignis UK Enhanced Income, both of which use similar strategies.
The Insight fund yields 8.35 per cent, making it the highest-paying fund in the IMA UK Equity Income sector, according to data from FE Analytics, while Ignis UK Enhanced Income yields 6.7 per cent.
Connolly says that for now it is safer to stick to the well-established fund houses.
"There’s an added degree of security in being with a big company like Schroders or Fidelity," he explained.
"If you are cautious about using these kinds of financial strategies you are likely to be reassured by being with these well-known big companies."