Ask an Adviser - How do fund managers use derivatives to create income?

Top answer provided by:

Ron Pratap

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Fund managers tend to use derivatives to create income in portfolios in a number of ways, especially at a time where cash and fixed interest rates are low and the share market is quite volatile. A derivative is a contract between two or more parties who agree to the value of an underlying asset which can include investments such as bonds, shares, currencies, interest rates etc.

Strategies can include the following and will change with each fund manager:

• Buying writes and selling put options-Selling a put option is advantageous to an investor, because he or she will receive a premium payment in exchange for committing to buy shares at a strike price. Put writing can be a very profitable method, not only for generating income but also for entering a stock at a predetermined price.
• Using Interest rate swaps- An interest rate swap is an agreement between two parties in which one stream of future interest payments is exchanged for another based on a specified principal amount.
• Purchasing shares that pay high dividends- This is when companies pay a sum of money on a regular basis to its shareholders out of its annual profits or reserves. This is in addition to te capital growth and share price.
• Investing in companies with Franking credits- This is a type of tax credit that allows Australian companies to pass on the tax they have paid at a company level to their shareholders. These franking credits can then be used to reduce income tax paid on dividends or entitle you to a tax refund.

Using derivatives to create income in a share portfolio is gaining popularity as there are a number of managers who use this approach to aim for a greater income return than your traditional sources. A number of benefits include:

-          Reduced volatility

-          Greater yields than dividends alone

-          Potential franking credits

-          Opportunity for some capital appreciation

-          Risk management

The main objective of these strategies is to have exposure to a diversified portfolio of shares while paying income on a regular basis. Eg. Selling call options (also called a ‘buy-write strategy’) means the fund is effectively selling some of tomorrow’s possible growth on a stock for an income premium today to reduce volatility. Although the use of derivatives provides extra income, it comes at the expense of capital growth.

In rising market conditions, derivative income strategies have lagged significantly from a total return perspective compared to traditional dividend and franking credit funds. Some may argue that the derivative income strategies tend to hold up pretty well in down markets, meaning they could be used as a supporting player to offer relatively defensive equity exposure.

I hope this helps in giving you an indication of how fund managers use income strategies in their portfolios and I would highly recommend speaking with a Financial Professional about your options and what strategy may work best for you when taking into account your goals and objectives as this area may be a little tricky and it is best to know the advantages/disadvantages of going down this path. 

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Article by:

Tim M from Sydney

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