Schroders sells upside to get maximum yield

Thomas See is the head of structured investment and head of the Schroder Income Maximiser management team.

Q: You took over the day-to-day running of the Income Maximiser fund in May when John Teahan left Schroders. What significant changes have you made to the portfolio?

A: The fund is run by a team of five fund managers – myself, Geoff Kirk, Ian Lance, Nick Purves and
Scott Thomson. Lance and Purves pick the underlying stocks so there is essentially no change following John’s departure. We were sad to see him leave but the strategy of the fund and how the overlay is chosen has not been affected. Because John was one of a team of managers there is still a lot of continuity in how the fund is managed.

Q: In April the fund was moved from the IMA Specialist sector to the UK Equity Income sector. What was the rationale behind this?

A: We run an equity portfolio so from that point of view it sits well in the Equity Income sector.

Our aim is to achieve a 7% yield. We want to sell some of the upside to produce yield, and this objective coincides with that of the IMA [Investment Management Association]’s Equity Income sector.

We think we are unusually placed to meet the aims of the sector. In step one of our process we replicate the Schroder Income fund, which has a 3.5% yield. In step two we can sell some of the upside over each stock we hold to produce another 3.5% yield on top.

Income Maximiser is a daily traded, open-ended fund, so all investors come in at different prices and we pay each investor 7% of the company share price.

Because of what we do, we have managed to reduce volatility – we lie somewhere in the middle of the cohort in risk terms. We are on course to deliver another 7% yield this year.

BP produces 13% of all the dividends in the market. A quarter of the dividends in the market are produced by just two companies – BP and Royal Dutch Shell. What does this mean for funds that sit in the Equity Income sector? It means you have to buy the same stocks, which leaves fund managers in an awkward position in terms of producing an absolute return. The sector is so concentrated. You end up bidding up the prices of the dividend producing stocks in the market.

The second step of our process allows us to meet the requirements of the sector to hold 110% of market yield. We put ourselves in the Specialist sector because the fund has quite an unusual strategy, but we think we fit better in the Equity Income sector.

Q: Have you revised down the fund’s yield target at all in recent months?

A: The reason yield is falling is because of the Bank of England’s decision to cut interest rates so low. Dividends are under pressure – analysts are forecasting a 5.2% dividend yield for the FTSE 100 for 2011. But there
is a swap market where you can buy and sell dividends. You can buy at 3% and get the 5.2% dividend. If markets see that yields will be 3%, it is conceivable we will take that
yield. But we have step two of our investment, which allows us to top up dividends to produce a 7% yield, so if dividends are cut it would not cause me parti­cular concern.

Q: How do you use put options within the fund?

A: We have started to use the flexibility of selling some of the upside on stocks in a different way. What we think are strong performers in the long term, we won’t overwrite.

For example, we thought banks had the capacity to rally strongly, and also housebuilders, of which we hold four. The banks rallied in the fourth quarter and we were in the happy position of taking all the growth. We cannot time single stockmarket events but we can take positions in line with our investment view.

We have recently started to overwrite banks again, and we also own four pharmaceutical stocks that we have overwritten.

Pharma has rallied so the strike price was extremely high. We have a strong fundamental view that pharma is a good purchase and is lowly valued. I only had a strike price of 110% offered to me, which is not high enough relative to the growth potential of the stock. Our analysts think each of our four pharma stocks is undervalued.

Of the four housing stocks we hold, we felt two were fairly valued and two were not, so we overwrote two of them. We can make use of these choices to produce yield and can make stock choices based on total return. We can even choose stocks with no yield as we are not constrained by that.

Q: What is main difference between the Income Maximiser fund and the Income fund?

A: Income Maximiser replicates the Schroder Income fund, which has a 21-year track record. It is a different portfolio to the standard income fund. We are underweight utilities and consumer goods – we have no tobacco, for example, which are classic areas for income funds.
We have large holdings in financials and healthcare. Both portfolios contain 45 stocks and there is about 97% replication of holdings.

Step two of the investment process marks out the difference between us and every other fund in the sector but surprisingly makes us more suitable for the Equity Income sector as we can achieve a higher yield when other funds are struggling.

Q: What has been the impact of fiscal stimulus and low interest rates in Britain on the search for income?

A: Interest rates will stay low for a long time [remaining at 0.5% in December 2009, rising to 0.75% in September
2010 and 1% in December 2010], according to Schroders’ in-house analyst’s ­predictions.

Rates are low for obvious policy reasons. We are looking at a future where public borrowing will rise. It is a difficult political situation, and it must be a real danger that inflation in future will be higher than expected.

At the same time people are looking for yield as they need it to live off. If you have been invested in cash in the last few years you would have been wise, but in the future returns will be so low after tax and inflation that if you compound them over time you will be building up a serious problem and negative returns.

Q: What do you expect the environment for dividends to be like going into 2010?

A: Inflationary pressures are building up. Most of us are in a difficult position of deciding what to do. Even cash may not be the safe option it appears to be. Earnings are affected in a prolonged recession – firms think it is prudent to conserve cash flow. It is hard to see how much further it may go – the prospect is for dividend cuts, which we have seen coming through, but we are confident we will continue to meet our yield target.