Face off: Fidelity Enhanced Income vs Schroder Income Maximiser

Two funds, similar strategies; one David, one Goliath. One has great long-term performance, but is weak over the short term, one has weaker long-term performance but has had a strong 2011. One has significant volatility, one has provided investors with more restful nights. Both offer a punchy income stream and are from reputable houses. It’s time for the battle of the enhanced income funds to commence.

At £771 million, the Schroder Income Maximiser fund was the pioneer of the approach in 2005 and has reaped the benefits of its first-mover advantage. The Fidelity Enhanced Income fund was launched in February 2009, when investors were feeling less flush, and has remained relatively small at £36 million.

Both funds take a large, well-established income fund, replicate the portfolio and then build a derivatives strategy over the top to provide investors with a higher income. The Schroders fund has been built on the back of the top-performing £1.1 billion Schroder Income fund, the Fidelity fund on the low-volatility £430 million Fidelity Moneybuilder Dividend fund.

The derivatives strategy is to sell options on the underlying portfolio. In effect, the fund manager trades the potential for share price growth for a fee. That fee is added to the overall income pot for the fund. For example, if a share was worth £1, the manager might sell the option to buy the share at £1.10, for which he would receive a premium of, say, 5p. If the share went to £1.20, he would have given away that extra 10p of gains, but would have an extra 5p of income. He is, in effect, sacrificing capital growth for income. As a result, both funds have a yield well above the sector average (6.26 per cent for the Schroder fund and 6.97 per cent for the Fidelity fund).

Tim Cockerill, head of research at Rowan Dartington, believes it is an extremely useful approach for income-seekers. He adds: ‘The options could cap the upside growth potential, particularly if the market rises strongly, but these funds are designed for those who want income. An income of almost 7 per cent is attractive.’

Fidelity Enhanced Income

In the red corner, the Fidelity Enhanced Income fund has been run by Michael Clarke since launch. David Jehan also works on the fund, managing the derivatives strategy. It is based on an old-fashioned income fund – Moneybuilder Dividend fund, also run by Clarke.

Clarke says: ‘Our investment strategy looks for income safety at a reasonable price. We are looking at the sustainability and growth potential of a company’s dividend. Cash generation is a key characteristic and we always invest in companies that generate surplus cashflow. We want to see a credible dividend policy, visible, sustainable earnings, which should distil down to an increasing dividend over time. We are careful on very high yields. It is often a sign of distress.’

As a result, the fund’s investments tend to be in areas such as large pharmaceutical and stable consumer goods companies. These are designed to be ‘no surprises’ investments: the companies have a predictable, long-term earnings stream and are high-quality businesses. Clarke buys them and tucks them away for the long term – turnover on the fund is just 25 per cent a year.  

This emphasis on quality has kept Clarke out of the oil majors: ‘For BP and Shell, maintaining and growing their dividend is a heavy burden relative to cashflow and capital expenditure requirements. They have been in a situation where cashflow is negative after the dividend and capital spending. In contrast, BG Group has a lower yield, but very strong production growth, so that is where we have invested.’

The result is consistency and low volatility, but returns are never likely to be exciting. The fund had a strong year in 2011 as risk-averse markets favoured the low-risk, quality shares in which it invests. It rose 8.9 per cent, leaving it comfortably in the top quartile of the IMA UK equity income sector. Over three years, performance is weaker. It is up 46.2 per cent, but is fourth-quartile in the sector. This is largely because it trailed the strong markets of 2009 and 2010.

It has one of the highest income levels in the sector at 6.97 per cent. The underlying portfolio has a reasonably high income at 4.22 per cent and the derivatives strategy brings the income higher. Clarke says: ‘The derivatives overlay dampens volatility, but one of the side-effects is to create a cap and collar on the returns.’

The impact of the trade of capital for income can be seen in a performance comparison with the Moneybuilder Dividend fund on which it is based. The latter fund is up 52.7 per cent over three years, so investors have effectively sacrificed 6.5 per cent of additional capital gain for three years of an additional 2.5-3 per cent income.  

Clarke believes that for this type of fund it is very important to be part of an organisation with an understanding of derivatives: ‘David Jehan has been in the business a long time and knows the market. It is not counterparty relationships, as such, but the team is vital.’

Fidelity Enhanced Income
Size: £36 million
Manager: Michael Clarke
Launched: February 2009
Yield: 6.97 per cent
Annual management charge: 1.5 per cent
TER: 1.76 per cent
Underlying portfolio based on Fidelity Moneybuilder Dividend fund
Contact: 0808 252 8851 or www.fidelity.co.uk

Schroder Income Maximiser

In the blue corner, Schroder Income Maximiser has been run by Thomas See since its launch in 2005. Schroders has recently launched enhanced income strategies in Asia and Europe. The UK fund has around 95 per cent commonality with the Schroder Income fund, run by contrarian investors Nick Kirrage and Kevin Murphy. See applies the derivatives overlay to generate the additional income.

Kirrage and Murphy had run the successful Schroder Recovery fund for some time before taking over the Schroder Income fund in 2010. Their style is a strict ‘value’ approach – they look for cheap, out-of-favour companies and hold them until they move back into favour. This means the fund will hold some uncomfortable positions.
The fund is concentrated, with around 40 shares, and is not managed relative to a benchmark. Its style means performance can be ‘lumpy’. Kirrage and Murphy will have long periods when they will be running counter to the market because they are digging in the unloved, unfashionable parts of the stock market.

This has been seen clearly in recent performance. Income Maximiser has outperformed over the longer term, rising 59.1 per cent over three years, though admittedly with high volatility. Short-term performance has been weak, partly because of its higher position in the financial sector – over one year the fund is down 4.3 per cent, leaving it in the fourth quartile.

The derivatives strategy adds a similar amount to the income that it does in the Fidelity fund, though the starting yield is slightly lower at 3.62 per cent.

See believes that the fund’s size is an advantage: ‘We have around £1 billion run out of Maximiser strategies and a dealing relationship with around a dozen counterparties,’ he says. ‘We are trading every week and that is important. It means that we can see the market and who’s active.’

Over the longer term, investors in the Schroders fund have had to sacrifice a little more of their capital for the income. The Income fund is up 68.6 per cent over three years, meaning investors have had to forgo 9.5 per cent of their capital for the additional 2.5-3 per cent income, but this would be expected as the underlying fund has performed better.

Schroder Income Maximiser
Size: £771 million
Manager: Thomas See
Launched: November 2005
Yield: 6.26 per cent
Annual management charge: 1.5 per cent
TER: 1.66 per cent
Underlying portfolio based on Schroder Income fund
Contact: 0800 718 777 or www.schroders.co.uk

The verdict

History suggests that with the type of value strategy employed on Schroder Income Maximiser, the best time to invest would be after a period of weaker performance as has been the case recently, but it is a riskier fund. The managers are higher octane, conviction-led investors and will have times when their performance looks very ugly indeed. Nevertheless, they have proved themselves highly capable managers over the long term.

Fidelity Enhanced Income fund is altogether a gentler beast. It is based on a basket of steady, predictable companies with stable cashflows and visibility of earnings. It also has a higher income. Performance is unlikely to be exciting and will look weak when markets run ahead, but it should allow investors an easier night’s sleep.

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