Are income funds just arbitrage funds?

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Question from Rob: My own personal pet peeve is ‘Dividend Income Funds’. The name would imply that such funds are invested so as to maximse DIVIDEND income, be it franked or not. Yet, the number of so called ‘Dividend Income Funds’ whose investment strategy is to access income-like outcome through the usage of derivative arb strategies confound. Whilst I accept such strategies may yield (pardon the pun) income- like results, they are not Dividend, they are not tax effective, nor as they paid out as received CASH. If we’re fair dinkum, then why not call them what they truly are,’Synthetic Arbitrage Funds’?:

Response from Rudi Minbatiwala, Senior Portfolio Manager with Colonial First State Global Asset Management and co-manager of the Colonial First State Equity Income Fund.

Rob, thanks for the question. As a Fund Manager in the ‘equity income’ space, we agree that investors need to take a closer look at strategies than just a fund name and think deeper about the concept of generating an income stream from equities. The confusion around the labelling of this space is understandable and reflects the challenges faced by researchers/consultants, dealer groups, advisers and by the wider industry in understanding the nuances of this heterogeneous space. While these funds are linked by the common objectives they seek to achieve, they can differ greatly by the approach they undertake, and the industry is rife with misunderstandings and over-simplifications with regards to a wide range of issues.

The common strategy of simultaneously buying shares and selling call options on those shares (called a buy-write strategy) changes the return path and return composition of the investment. We actually agree that too often this derivative strategy is positioned with an over-emphasis on the income aspect of the strategy. Selling call options over some of the shares you own is another way to reflect your investment view on that share. It is an investment tool; it is not an ‘arbitrage’ concept.

A buy-write strategy should be considered in terms of an ‘asset-liability’ concept. The option premium income received is an ‘asset’ that is obtained when the call option is sold. The size of this ‘asset’ is fixed and known at the time of implementation. This makes targeting a desired level of income (cashflow) relatively straightforward. However, the option premium income that is generated is not ‘free’; the capped share price upside represents an unknown ‘liability’ that changes in value with the passage of time and market movements.

Like all liabilities, this call option liability needs to be properly managed and the key drivers of the liability need to be understood. The relevant risk factors impacting the value of the call option liability on a share are the same stock specific risks and market risks impacting the underlying share prices.

Understanding the distinction between generating an additional distributable income stream and managing investment returns is critical. In the same way you always consider what shares you buy, and what price you pay for those shares, you must apply the same basic investment principles to the selling of options. For your highest conviction shares in your portfolio, you are likely to only cover some (or none) of your shares with options, and seek more upside exposure for the call options you implement. For other shares, you will prefer to cover more of your holdings and position the options closer to the current share price. This will generate additional income for your portfolio and provide a greater downside cushion. Simply selling options over all of your shares, all of the time, is likely to lead to a sub-optimal outcome.

Therefore, a focus on just the income generation from using derivatives is an over-simplification that needs to be avoided by outcomes focussed investors. Certainly not all equity income products that utilise derivatives are the same. The challenge for the industry remains in developing a greater understanding of what approaches are most suitable in meeting investor objectives, and this involves assessing the merits of each fund or strategy from first principles.

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One Response to Are income funds just arbitrage funds?

  1. Fred Woollard December 22, 2013 at 5:12 PM #

    The article conveniently overlooks two nasty realities about “buy-write strategies”.

    Firstly, a person who engages in a buy-write strategy ends up with potential outcomes that are very similar to sitting in cash and writing put options – ie you get limited upside but potentially large downside, especially in a market crash like the GFC or October 1987. Such a mixture of risk and reward potentially makes sense for a professional gambler or a well-diversified investor or insurance company, but probably not for a retired investor seeking income and safety of principal.

    Secondly, even for a professional, option writing only makes sense if the premium received more than compensates for the risks incurred. Today, implied volatility (the professionals’ preferred measure of option premiums relative to risk) is close to a 20-year low. In plain English, option writers are not being paid well for the risks they are incurring. I doubt that many of the underlying investors in buy-write funds, or even their financial planners, are aware of this.

    Still, there is a silver lining to every cloud. My fund has recently been buying options at ridiculously low prices and I hope we can buy more. I suspect some of these options have been indirectly provided by Mums and Dads who have been mis-sold the risks inherent in “income funds” boosting their “income” by writing covered calls at cheap prices.

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