Weekly outlook

No free lunches

By Tom Stevenson, 28 January 2009

The launch of Fidelity’s new Enhanced Income Fund shows it’s not the risk that matters but how well you understand it It is a fact of life in investment that bigger rewards generally come at a price – usually they involve bigger risks. If you really cannot bear the thought of losing any of your capital, then you have to settle for the sometimes paltry returns available on a cash deposit. The cost of security has never been as obvious as it is today, with instant access returns as close to zero as makes no difference. If, like most people, you hope for a better return than most banks are currently offering, you need to start assessing and understanding the risks you are taking and measuring them against your expected returns.

"The key to managing risk is to understand what risks you are taking" Tom Stevenson

Some risks are fairly obvious. Individual shares can rise by 30% or more in any given year but only in an exceptional bull market do mutual funds tend to rise by that sort of margin. The trouble, of course, is that many individual shares also fall by that sort of percentage. The shoot- the-lights-out winners may be diluted in a well-diversified fund but so, too, are the disasters.

Sometimes risks are less obvious. Some investors are tempted by the promises offered by so-called guaranteed products but not all understand what goes on beneath the bonnet of these seemingly safe investments. The last year has shown that counterparty risk (the chance that the organisation on the other side of a financial transaction goes bust) cannot be ignored. When Lehman Brothers filed for bankruptcy, some investors lost everything in “guaranteed” products.

Size is no guarantee of security either, as the implosion of some big banks in recent months has shown. In years gone by the generous dividend yields and apparent solidity of Britain’s High Street banks made them popular investments with private shareholders. But Royal Bank of Scotland, for example, has lost pretty much its entire value over the past year.

Sometimes the risk is something wholly unexpected. The devastating impact of spiralling inflation in the 1960s and 1970s on the value of fixed-interest investments such as government bonds (gilts) illustrates this well.

The key to managing risk is to understand what risks you are taking and to make sure that they fit in with your goals.

For example, Fidelity is launching an Enhanced Income Fund, aimed at the many savers and investors who need more income than they can find in the safest assets such as cash and government paper.

Enhanced Income is not a risk-free product, but anyone investing in it can quite easily understand the risks involved and decide whether they are comfortable with them.

Enhanced Income works like this. First, its fund manager, Michael Clark, constructs a portfolio of relatively high-yielding UK-listed stocks, taking great care to avoid situations where an apparently attractive dividend fails to be maintained (dividend cuts and subsequent falls in share prices are one very obvious risk).

Then he enhances the fund’s high income even further by selling to other investors the option to buy selected shares in the portfolio at an agreed higher price before an agreed date in the future. The premium income he receives is added to the fund’s dividend income, which is how Enhanced Income is able to aim for an initial yield of around 7%.

This is called selling a call option. Because Michael only sells other investors the option to buy shares that he already owns in the portfolio (they are “covered” call options), he eliminates one important risk. He will only ever have to sell something he owns. He knows that if the buyer of the call option decides to take up his right to buy he will be able to complete the deal and at a pre-determined price.

That pre-determined price is decided by Michael and is on or above the value he places on the company. It is moreover a very efficient way to move out of an investment that has hit his target price.

But there is an unavoidable risk for the fund, which is that the price of a share rises rapidly and triggers the exercise of the call option – in other words, the other party in the trade decides to buy the shares at the agreed price that is now lower than the market price. If this happens, the fund has profited from the rise in the share price up to Michael’s judgement of the value of the company, but misses out on any subsequent capital gain if the share continues to rise. Of course, this is true whenever a portfolio manager exits a stock.

If you think about it, it would be surprising if such an attractive income could be generated in today’s low-interest environment without some sort of risk – in this case the risk of opportunity loss. But having understood the possible price to be paid, an investor can make up his or her own mind. If their priority is a high income in an environment where that is hard to find, and if they are prepared to forego capital gains above a certain level to secure that income, then they may well decide that it is a risk they are happy to take.

Remember, there really is no such thing as a free lunch.

Fidelity Enhanced Income Funds launches on 2nd February 2009
The estimated yield at launch of 7.1% is based on 150% of the prevailing yield on the FTSE All share of 4.75% (as at 15/01/09). This is at the lower end of the Fund's target 150 - 200% range. Net of basic rate tax. The estimated yield at launch is quoted as an estimate and is not guaranteed. The yield will fluctuate in line with the yield available from the market over time. Details of this fund will be available from 2nd February.