While the sector’s rules require a minimum 80 per cent investment in equities at any one time there are no specific rules mentioned by the Investment Management Association with regards to using strategies such as call options to boost yield.The IMA UK Equity Income sector remains one of the most popular for investors having topped the tables as the bestselling IMA sector for the past three months, demonstrating the huge value investors are placing on income.
The popularity among investors of pensionable age, who may rely on regular dividends for income, looks set to increase with a demographic trend of an ageing population and increasing life expectancy.
Slater, who runs the £50m MFM Slater Income fund alongside co-managers Barrie Newton, Bryan Quinton and Ralph Baber, says there are several funds in the sector that generate part of their yield from sources other than equities.
“A fund that is paying a decent yield that is based on the underlying yield of the companies held in the fund is a more attractive proposition compared to a fund where the yield is coming from other sources. The investor needs to know what the source of yield is.”
“You need to know because it affects one of the indicators of value: the level of yield. If that isn’t based on company dividends or only 70 per cent is based on company dividends that is a meaningful thing an investor needs to know.”
“It is a perfectly legitimate strategy to try and boost the yield. It definitely goes on and it isn’t the dirty secret of the income world but clearly if a fund is offering a 4 cent yield and one percentage is coming from lower quality sources that is relevant for investors.”
Apart from holding equity in listed companies and waiting for if/when they pay out dividends, Slater says there are several ways funds can add to their dividends without breaking the sector’s rules.
“One way people do it is to do dividend stripping – buying high paying stocks before they pay a dividend. However, in the current environment this doesn’t work although some might be tempted by that.”
“The other option – which makes a bit more sense - is to put call options against existing holdings. Although the premium you get is pretty low and there are times when it is more attractive, it is a legitimate thing to do but for an investor in funds it is very important to understand what the source of yield is.”
However, Slater says it is hard to ascertain if a fund had been asset stripping as it wouldn’t show up on their fact sheet.
“If they have nipped in and out of a high dividend paying stock you wouldn’t really know. We keep it simple; dividend stripping is usually a waste of time.”
Slater says such practices also put capital growth at risk, especially with markets flatter this year and a more subdued outlook after several years of steadily upward markets.
“The markets are reasonably efficient and in the current environment where people are very hungry for yield you are likely to lose on the capital side more than you get on the income side. There are a lot people looking for income and so it is more likely to lose on that side.”
Higher yielding funds can carry a larger risk to investor capital and although the holding of an income fund is to generate a regular stream of dividends, a fund that loses capital or grows it more slowly can erode total return.
Darius McDermott, managing director at Chelsea Financial Services and an AFI panellist, says some managers who engage in call options are quite open about it but he expects other income managers may engage in the process to meet the IMA UK Equity Income sector’s 110 per cent yield target.
“If you look at Schroders' or RWC’s enhanced products they blatantly use call options to get premium income on stocks but they could also be used by managers around the edges as part of their process to stay in the sector. It is hard to say if it is happening but I wouldn’t be surprised.”
According to FE Analytics, the MFM Slater Income fund has returned 64.56 per cent over the past three years compared to an IMA UK Equity Income sector average of 46.78 per cent and a gain in the FTSE All Share of 40.35 per cent.
Performance of fund, sector and index over 3yrs
Source: FE Analytics
Slater holds a mixture of large, small and mid-caps across his three funds although there is an apparent bias to larger caps in the income fund.
