Business Times - 19 Sep 2007


In search of yields

Be aware of the trade-offs when investing in unit trusts that promise high coupons of 10% a year currently, says GENEVIEVE CUA

YIELD remains a powerful draw for investors, and with the recent market correction, the expected yields on a number of listed funds represent a fairly attractive premium over deposit and Singapore bond rates.

In the unit trust arena, the highest headline coupon that some funds are currently marketed at is 10 per cent a year. That may sound attractive, but are you fully aware of the trade-offs?

Several of the funds generate an income through an equity portfolio's dividend payouts, in addition to an options strategy. Typically, the fund would sell call options on its underlying holdings. This gives it extra income to distribute.

Several funds also claim to offer a level of so-called protection by also buying put options on its stocks. Puts, however, do not actually protect the investor's capital in the event of a steadily deteriorating market. The accompanying graphic for unit trusts reflects the indicated yield in the first year based on a launch price of $1. There is no indication of current yield. This is because, unlike listed funds, unit trusts rarely give any dividend guidance, if at all.

First off, the listed funds sector. Some of them offer exposures that individuals typically would find hard to invest in on their own. These include the Babcock & Brown Structured Finance Fund, which aims to generate capital gains and dividends from its portfolio of operating leases, loan and securitisation assets as well as alternative assets. The fund's price suffered a drop recently, thanks to its exposure to collateralised debt obligations (CDOs), which it has clarified are unrelated to troubled sub-prime mortgages.

First Ship Lease Trust also leases out its assets, including tankers and container ships, out of which it pays dividends.

The listed funds sector is perhaps relatively easier to grasp. Typically, a fund - whether a real estate investment trust (Reit) or infrastructure fund - would hold certain assets out of which it earns a stream of income that is subsequently distributed. In these cases, the underlying businesses may rise and fall alongside general business and economic conditions.

In the unit trust sector, structured funds may not be as straightforward. This is ironic, as investors in unit trusts are more likely to have a fairly unsophisticated profile.

A level of complexity is added by the widespread use of derivatives, which will involve trade-offs that the investor may not find very transparent or easy to understand.

Dr Thomas See, Schroders' co-head of structured investments, says: 'Many investors don't understand. They believe - here is a high level of protection and high exposure to market, plus 10 per cent dividend. But the two are incompatible.'

One fund that sources believe has caused some concern is Barclays' Bonus Select Income Fund. This fund was launched this year with a level of protection as well as income. It uses two strategies: an options strategy to deliver the yield, and a type of quantitative portfolio insurance to achieve some level of protection. The latter strategy - technically called CPPI - has earned a poor reputation until its recent re-emergence among retail funds.

Sources say distributors of the fund are nervous that a recent sharp drop in the fund's net asset value could bring the NAV close to the point where the fund is 'knocked out' or monetised. The latter means that a market shock could force the fund to be invested mainly in cash or bonds, and hence unable to generate an upside in the future.

This happened earlier with a few unit trusts between 2000 and 2002, and for distributors involved in that debacle, it makes an unwelcome deja vu.

Monetisation

Sources believe Barclays has written to the banks to explain the fund's position. Barclays executives are unavailable for comment, although an executive has indicated that at the current price of $0.89, 'there is still sufficient cushion'. The NAV at which a monetisation may be triggered is undisclosed.

Based on Bloomberg data, the fund's price has fallen sharply from $0.95 at the start in April to a low of $0.88. It has since inched up to $0.89.

Schroders has just rolled out its Global Dividend Maximiser fund, which will pay an indicative coupon of 8 per cent a year. This strategy aims to make payouts from premiums that it earns from selling call options and dividends from the portfolio. There will be no purchase of puts.

The fund has struggled somewhat to find acceptance among banks which are accustomed to the psychological comfort of a put option. In reality, most funds buy short-dated puts that put a floor to a fund's downside at 90 per cent of a fund's NAV. In a declining market, rolling over the puts every three months could still spell a substantial loss for investors.

So, what lessons can be learnt?

Dr See says it is useful to think in terms of a 'risk budget' based on the prevailing risk-free rate. In Singapore, this could be the 12-month interbank rate, currently at 2.75 per cent.

After fees of about 2 per cent, this benchmark rate will drop to just 0.75 per cent. Taking the most generous assumption of zero fees, Dr See believes the risk exposure a fund can take is only 30 per cent if it is to buy some protection as well. If so, a fund that promises to distribute as much as 10 per cent in income may be taking inordinate risk possibly through leverage, particularly in the early years of the product.

'In marketing products, there is an inconsistency in what products suggest they can do, and what the investment is actually capable of doing. This could lead to over-exposure (to risk) in the early years,' says Dr See.

There are other things to note with options. Selling a call will cap your potential upside, for one. With Barclays funds, the call's strike is typically set at 102 per cent. This means you can see an upside gain of only 2 per cent on the underlying stocks. You should, however, earn a higher premium income as there is a greater likelihood of being struck.

As for managers who claim to be able to opportunistically buy put options, Dr See sounds a caution. 'I'd say there are very few occasions when fund managers have certain knowledge . . . Imagine that you can switch your investment on and off. When you switch it off when the market falls, you have lost money.'


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