Seven per cent income from UK equities with Schroder

IC TIP RATING

Tip style: INCOME

Risk rating: HIGH

Timescale: LONG TERM

The fund targets a yield of 7 per cent by using an innovative strategy in order to generate extra income on top of returns and dividends from its holdings. It uses the same stock selection strategy as the Schroder Income Fund, targeting undervalued UK companies with the potential for capital and dividend growth, but uses derivatives to boost its income on selected stocks. By issuing short-dated option trades on selected stocks from its portfolio, it is able to add around another 3.5 per cent in maximised income from the market. The strategy means it can make more money on selected stocks than it could earn from dividends and share price appreciation alone.

The 'covered call' overlay works by issuing call options to the market on certain stocks. The fund guarantees it will sell securities it holds at a certain price, regardless of where the market moves, for a fee. If those securities appreciate, the buyer is able to buy them for a better price within a set time limit. The downside of the strategy is that the fund may give up some capital growth if the share price of those securities rises higher than the set price, known as the strike price, within the expiry date. As a result, the fund leaves some of its holdings without options - currently 25 per cent.

However, the higher income received by investors compensates for that risk and for those with a main focus on income rather than capital growth, the high dividends are appealing. According to its most recent report, the fund delivered on its latest income target with a distribution of 1.6 per cent for the quarter ending 28 February 2015 and delivered a distribution of 7.19 per cent in 2014, exceeding its 7 per cent target. That compares with a 3.8 per cent historical yield for Schroder Income Fund A Acc, according to Morningstar.

Stockbroker Killik & Co recently updated and reiterated its buy recommendation on Schroder Income Maximiser. Mick Gilligan, head of fund research at Killik & Co, says: "The track records of both funds highlight the strength of the strategy implemented by the Schroder Value Team, in addition we believe that Schroder's analyst resources and the managers' execution provides further benefits."

Schroder Income Maximiser fund looks for companies with the largest potential for capital and dividend growth in the UK. It uses the cyclically adjusted price-earnings ratio (CAPE) to evaluate stocks, which tries to strip out the distortions connected to variations in the business cycle of companies. Mr Gilligan says: "There is good evidence to suggest that a value-driven investment approach, based on buying at low CAPE valuations, leads to above average capital gains over time."

Managers Nick Kirrage and Kevin Murphy look for value in unloved or out-of-favour sectors such as UK banks or supermarkets and believe that investing in cheaper companies leads to better returns over time. Recently they have added to J Sainsbury (SBRY) and Tesco (TSCO) in the belief that the threat posed by discount rivals is compensated for by the supermarkets' low valuations and financial strength. That contrarian approach can lead to periods of underperformance but also strong rallies and means this is a fund to hold for the long term.

The fund is volatile, in part due to its concentrated portfolio - it holds between 35 and 50 stocks making it potentially a more risky option than other equity income funds. In the year to date it has underperformed the FTSE All-Share and posted a lower total return than the Schroder Income fund. But it outperformed the FTSE All-Share in 2012 and 2013 and offers a higher yield. The lowest cost Z share class is available on platforms for an ongoing charge of 0.86 per cent.

For investors keen on a much higher yield than traditional equity income funds and prepared to hold for a long time period, this fund offers income and the prospect of a reasonable, though variable, amount of capital growth. Buy.

Source: Morningstar, as at 27 May 2015

Calendar year total return (%) of fund against benchmark

Source: Morningstar and FE Trustnet, as at 18 May 2015

Top 10 holdings

Source: Schroders.com

Sector weighting

Source: Schroders.com