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Fund Spy: Deriving value amid low rates and volatility

Glenn Freeman  |  23 Oct 2019Text size  Decrease  Increase  |  
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Derivative income funds may be a dirty word for some investors, but they can produce market-beating returns.

Australia's ageing population means sources of investment income are highly prized, but in a time of record low interest rates and volatile equity markets, there are few safe options.

One vehicle to consider is a derivative equity income fund. A derivative equity income fund makes use of derivatives—contracts between two or more parties whose value depends upon or is derived from—one or more underlying assets.

In this case, those assets are companies listed on the Australian Securities Exchange.

A derivative income fund uses “call” and “put” options. A call option gives an investor the right to buy at a certain price. A put option is backed by cash and gives an investor the right to sell at a pre-determined price.

“Derivatives are a bit of dirty word to investors,” says Michael O’Neill, portfolio manager at Investors Mutual Limited. He notes they can be quite complex, but there are ways to use derivatives that are "low risk and quite predictable".

A derivative equity income fund typically targets one or more of the following objectives:

  • Income
  • Volatility
  • Return
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In this article we will examine three of Morningstar's preferred derivative income strategies:

  • Investors Mutual Equity Income (12285)
  • CFS Wholesale Equity Income (16354)
  • Merlon Australian Share Income Fund (3683)

Equity income

Morningstar always has a cautious view on more complicated options strategies within income funds, and our ratings almost always favour those employing simpler approaches. Some managers use call and put options to lower the volatility of investment returns, and others use them purely to increase income—and some do both.

It's also worth remembering that just as derivatives can reduce risk, they may also limit the potential rewards. For this reason, Morningstar focuses on the total return outcome.

IML’s steady eye on earnings

The Investors Mutual offering focuses on companies with steady and predictable earnings, and particularly on those paying above-market dividends.

Three of Australia's big four banks—Commonwealth Bank (ASX: CBA), National Australia Bank (ASX: NAB) and Westpac Bank (ASX: WBC)—rank among its top five holdings. BHP Group (ASX: BHP) and biotech CSL (ASX: CSL) are also top-ranking stocks in the portfolio.

Other companies in the portfolio's top 10 are Telstra (ASX: TLS), global packaging company Amcor (ASX: AMC), casino operator Crown Resorts (ASX: CWN) and betting house Tabcorp (ASX: TAH).

The fund has consistently met its income objective of beating the S&P/ASX 300 by 2 per cent, after fees and before franking credits. Whereas the index generated yield of 4 per cent in 2018, the IML strategy returned more than 7 per cent.

Call options are the team's most commonly used derivatives, covering up to 30 per cent of the fund's portfolio holdings in order to extract income—a premium—when it believes individual company share prices have surpassed their fair value.

O'Neill says IML can generate additional premium income of more than 2 per cent using "simple options strategies". However, he stresses the team avoids taking such covering positions in too many stocks, to avoid the dividend trap of swapping capital growth for income.

Merlon: chasing above-market income yield

Merlon's fund within this category uses the premium earned on equity income to purchase put options—short positions—in stocks it already holds. For example, if the fund holds 20,000 shares in Commonwealth Bank, it would typically hedge around 6,600—roughly 30 per cent—of these. This is part of its overarching risk-reduction strategy.

An above-market income yield is one of the objectives of the Merlon Australian Share Income fund, though Merlon principal Andrew Fraser and his team avoid nominating a specific percentage yield in excess of the benchmark.

The fund also has a low-volatility objective, targeting 30 per cent less share price movement than the S&P/ASX 200.

Like IML portfolio manager O'Neill, Fraser believes many local fund managers place too much emphasis on the income component of total return. The Merlon fund also prefers to invest in undervalued companies with both growth and yield prospects—rather than simply selecting stocks with a history of paying high dividends.

Fraser even casts doubt on the presence in an income fund of dividend darlings like Telstra.

The manager recently remarked the telco giant's dividend is completely unsustainable. Telstra and its investors have enjoyed margins of up to 45 per cent on selling access to a copper network, but the National Broadband Network is now taking a heavy toll.

"We see a scenario where Telstra is worth less than $2 a share [versus its current price of $3.60]. We may be right, we may be wrong, but we don't think it's appropriate to be investing on the basis of the dividend alone," Fraser says.

First Sentier: puts and calls

The income fund from Colonial First State, now known as First Sentier Investors, also leans toward call options over puts in its use of derivatives to alter the way income is generated.

The portfolio management team typically only writes options over two-thirds of the stock holdings, which usually number around 30 to 40 companies in total.

Gaming company Aristocrat Leisure (ASX: ALL), CSL and consumer staple A2 Milk (ASX: A2M)—which all carry Morningstar narrow moat ratings—are the First Sentier fund's main active positions as of 30 June 2019.

Morningstar fund analyst Matt Wilkinson notes that the strategy has returned 6.83 per cent a year since its 2008 inception and the end of August 2019—well ahead of the category average and slightly beating the index.

Wilkinson queries the income returns, which have at times exceeded its total returns, "meaning there has been a slight erosion of capital for that income," he says.

The fund tends to perform much better in down or flat markets than in rising markets, which Wilkinson describes as a natural pitfall of any options strategy.

But the fund's volatility objective has been successful in providing much smoother returns than its S&P/ASX 200 benchmark.

is senior editor for Morningstar Australia

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