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Income-generating Funds Find Favour

By Telis Demos

  • 10 Jan 2012

Institutions and retail investors are shifting money into income-generating equity funds as they shy away from funds and strategies that rely on capital gains.

Though US stocks were little changed in 2011, a surge in volatility and the prospect of sustained, low interest rates by the US Federal Reserve have generated strong demand for stocks that pay dividends and strategies that use options to generate income.

“A lot of people are disenchanted by stock markets, but the way that interest rates are, people are still hungry for risk management and yield strategies,” said Matthew Moran, vice-president of institutional marketing at the Chicago Board Options Exchange.

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Income-focused equity funds that specialise in solid companies with high dividends saw inflows of $31bn last year, according to Lipper, which tracks fund flows, while capital growth-focused strategies on large- and small-cap shares saw outflows of $84bn.

The top 50 highest-yielding stocks in the S&P 500 achieved total returns of 8 per cent, according to Birinyi Associates, while the broader index returned 2.5 per cent, including dividends. Meanwhile, stocks with the 50 highest valuations, as measured by price-to-earnings ratios, shed 17.8 per cent.

Returns were also generated by selling at-the-money options against the S&P 500 index, a strategy known as “buy-write” that gives up some prospects for capital growth but generates income from the premium collected by selling these options. The CBOE Dow Jones Industrial Average Buy-Write index, which tracks the strategy, returned 8 per cent last year.

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More exotic funds, such as those that focused on buy-write strategies, nearly doubled their inflows, adding $639m in 2011, compared to $376m the previous year, according to Lipper. CBOE estimates that some $30bn in assets are now benchmarked to its buy-write index.

“What used to be polite deflections have now become ‘I want to see more’,” said Tom McKeon, a former options trader who recently launched Clothier Springs Capital Management, an investment adviser focused exclusively on buy-write strategies.

Though valuations on higher-yielding stocks have reached rich levels, and many strategists predict gains for stocks this year, additional funds are still being committed to yield-focused strategies, even though such strategies typically underperform in markets when share prices are rising quickly.

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For example, municipal pension funds in Seattle and Los Angeles and state funds in Florida and Hawaii, have recently added or are exploring allocations to buy-write and income strategies.

“If we have a massive bull market, people are going to go back to investing in equities the way they did,” said Jason Ungar, equity product specialist at Guggenheim Partners. “But most of us believe there are an awful lot of risks and volatilities, and equities going forward may not be able to return what they have historically.”

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