"In investment management the marketing department is busy creating the headline that will entice investors to park their money in a particular fund," said a recent note from RWC.
"The hook is either based on a wonderful story, such as ‘the future is renewable energy’ or emerging markets or some other ‘irrefutable’ theme. The hook strips the nuance from the product, which is fine if the investor follows up with some due diligence prior to investment, but often this process is overlooked."
Nick Purves, who manages RWC Enhanced Income alongside John Teahan, added: "Fund managers have a very bad habit of building up their own asset class. Also beware of any fund manager who looks at one-year P/E and tells you the market looks good value. Because the problem is the earnings fly around. We think it is much more robust to look at cyclically adjusted P/E which is today’s price divided by the average earnings over the previous 10 years. What that tries to do is strip out the effects of the economic cycle."
The managers aim to deliver a 7 per cent yield in their fund, but are keen to explain why this is realistic and encourage investors to carry out their own research if they are sceptical over whether the sums add up.
"Take a look at the free cash-flow yield," said Purves. "This is the amount of cash a company can distribute without damaging the fabric of the business or impeding its growth prospects."
"For the average stock in the portfolio it is 10 per cent. Of the 10 per cent, the companies pay half of this as a dividend. The other 5 per cent can be used to invest in the business, or fund future dividend growth. If it is at 10 per cent it leads us to believe the underlying stocks in the fund are sustainable and can grow over time."
Teahan added: "Because the dividend is twice covered in so many of our stocks, when people ask me if the 7 per cent is sustainable, I can say 'yes'."
To make up the rest of the 7 per cent yield, the managers use a type of derivative called a covered call option. Teahan says derivatives don’t deserve their reputation for being complicated and that the covered call option is no different.
"This is a very simple strategy," he commented. "All it means is that, for example with Vodafone, if it is trading at 170p, we can sell a three-month option in which we give away any upside above 190p in exchange for, say, 2p in income premium on top of the dividend. With the dividend on Vodafone currently at 9p, you can see how we quickly get to 7 per cent."
"We do that on each individual stock. The trade-off for us is if the stock does very strongly and goes through the strike, we cap our upside, we give away any upside above a certain level. On the other side, if the stock goes down or remains flat, you can see we’re always adding to the total return on the income side."
"People get caught up in this overlay, but this is really just a traditional equity fund. All we’re doing is enhancing our dividend by a third."
Teahan says many people are wary about derivatives, due to worries they will be left exposed if the investment bank fails. This is not a problem with the call option he uses, however.
"Usually when you buy a derivative you buy protection and there is payment to you at the end of that contract," Teahan continued.
"With these options, because we’re selling them we receive the payment up front – we sell the option to our investment bank and then a few days later we receive the payment from them. At the end of the three months the next payment is made, if there is one."
"Going back to my Vodafone example – if it has gone beyond £1.90, say if it has gone to two pounds, then I need to make a 10p payment on every share to the investment bank. If anything happens to the investment bank in that period, it doesn’t impact our fund or clients."
"It surprises me that more fund managers don’t use the call overlay within income funds. It comes down to a lack of familiarity."
Performance of fund since launch vs sector
Source: FE Analytics
According to FE Analytics, RWC Enhanced Income has lost 6.25 per cent since launch, compared with positive returns of 5.17 per cent from its FO Equity sector.