Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Are income funds just arbitrage funds?

Question from Rob: My own personal pet peeve is ‘Dividend Income Funds’. The name would imply that such funds are invested so as to maximse DIVIDEND income, be it franked or not. Yet, the number of so called ‘Dividend Income Funds’ whose investment strategy is to access income-like outcome through the usage of derivative arb strategies confound. Whilst I accept such strategies may yield (pardon the pun) income- like results, they are not Dividend, they are not tax effective, nor as they paid out as received CASH. If we're fair dinkum, then why not call them what they truly are,’Synthetic Arbitrage Funds’?:

Response from Rudi Minbatiwala, Senior Portfolio Manager with Colonial First State Global Asset Management and co-manager of the Colonial First State Equity Income Fund.

Rob, thanks for the question. As a Fund Manager in the ‘equity income’ space, we agree that investors need to take a closer look at strategies than just a fund name and think deeper about the concept of generating an income stream from equities. The confusion around the labelling of this space is understandable and reflects the challenges faced by researchers/consultants, dealer groups, advisers and by the wider industry in understanding the nuances of this heterogeneous space. While these funds are linked by the common objectives they seek to achieve, they can differ greatly by the approach they undertake, and the industry is rife with misunderstandings and over-simplifications with regards to a wide range of issues.

The common strategy of simultaneously buying shares and selling call options on those shares (called a buy-write strategy) changes the return path and return composition of the investment. We actually agree that too often this derivative strategy is positioned with an over-emphasis on the income aspect of the strategy. Selling call options over some of the shares you own is another way to reflect your investment view on that share. It is an investment tool; it is not an ‘arbitrage’ concept.

A buy-write strategy should be considered in terms of an ‘asset-liability’ concept. The option premium income received is an ‘asset’ that is obtained when the call option is sold. The size of this ‘asset’ is fixed and known at the time of implementation. This makes targeting a desired level of income (cashflow) relatively straightforward. However, the option premium income that is generated is not ‘free’; the capped share price upside represents an unknown ‘liability’ that changes in value with the passage of time and market movements.

Like all liabilities, this call option liability needs to be properly managed and the key drivers of the liability need to be understood. The relevant risk factors impacting the value of the call option liability on a share are the same stock specific risks and market risks impacting the underlying share prices.

Understanding the distinction between generating an additional distributable income stream and managing investment returns is critical. In the same way you always consider what shares you buy, and what price you pay for those shares, you must apply the same basic investment principles to the selling of options. For your highest conviction shares in your portfolio, you are likely to only cover some (or none) of your shares with options, and seek more upside exposure for the call options you implement. For other shares, you will prefer to cover more of your holdings and position the options closer to the current share price. This will generate additional income for your portfolio and provide a greater downside cushion. Simply selling options over all of your shares, all of the time, is likely to lead to a sub-optimal outcome.

Therefore, a focus on just the income generation from using derivatives is an over-simplification that needs to be avoided by outcomes focussed investors. Certainly not all equity income products that utilise derivatives are the same. The challenge for the industry remains in developing a greater understanding of what approaches are most suitable in meeting investor objectives, and this involves assessing the merits of each fund or strategy from first principles.

  •   13 December 2013
  • 1
  •      
  •   
1 Comments
Fred Woollard
December 22, 2013

The article conveniently overlooks two nasty realities about "buy-write strategies".

Firstly, a person who engages in a buy-write strategy ends up with potential outcomes that are very similar to sitting in cash and writing put options - ie you get limited upside but potentially large downside, especially in a market crash like the GFC or October 1987. Such a mixture of risk and reward potentially makes sense for a professional gambler or a well-diversified investor or insurance company, but probably not for a retired investor seeking income and safety of principal.

Secondly, even for a professional, option writing only makes sense if the premium received more than compensates for the risks incurred. Today, implied volatility (the professionals' preferred measure of option premiums relative to risk) is close to a 20-year low. In plain English, option writers are not being paid well for the risks they are incurring. I doubt that many of the underlying investors in buy-write funds, or even their financial planners, are aware of this.

Still, there is a silver lining to every cloud. My fund has recently been buying options at ridiculously low prices and I hope we can buy more. I suspect some of these options have been indirectly provided by Mums and Dads who have been mis-sold the risks inherent in "income funds" boosting their "income" by writing covered calls at cheap prices.

 

Leave a Comment:

RELATED ARTICLES

Expect disappointment as values become stretched

Term deposit investors did not understand the risk

The thin line between investing and gambling

banner

Most viewed in recent weeks

It’s time for LICs to die

A high-profile dividend cut and a prominent fund manager’s apology have reignited a long-running debate. If investors can access similar exposures more cheaply and efficiently elsewhere, what exactly is keeping LICs alive?

Testamentary trusts survived the trust tax. The drafting battle has just begun.

The fight over testamentary trusts looked settled. Then the draft legislation arrived. Hidden in a technical detail is a question that could force many families to rethink wills they thought were already future-proof.

Is it time to bail on Australian stocks?

For generations, Australian investors have backed banks, miners and dividends. But has that loyalty come at a cost? A look at the numbers raises an uncomfortable question about where future returns will come from.

The new capital gains tax trap for your portfolio

Investors have long accepted one portfolio rule without much question. A major tax shift could change that calculation entirely, forcing difficult trade-offs between risk, discipline and an overlooked cost lurking beneath.

How the typical Australian Family could save $844,350 in taxes

The value of a testamentary trust is not determined by wealth alone. Depending on circumstances, it can reduce the tax burden on inherited income, create efficiencies and help build intergenerational wealth.

The housing slide could become a crash

House prices are sliding across Australia, yet the most dangerous ingredient for a housing crash is still missing. If job losses surge amid growing economic risks, today's correction could become a historic property downturn.

Latest Updates

Retirement

The retirement scorecard: how many of these questions can you answer?

From the maths of retirement, estimating spending and picking the right asset allocation to survive a poor decade, here are the questions every retiree – current or future – should be able to answer for themselves.

2026 is not 1999

The US market looks eerily similar to the dot-com era with soaring AI spending and tech giants dominating returns. But one difference separates today’s boom from the dot-com bubble and it could determine what happens next.

Planning

Taxing time for trusts

Trusts are facing a shake-up, but an overhaul may not be necessary. Families can explore restructuring strategies that preserve succession and the asset protection benefits that have made these structures valuable.

Economy

Why the US economy is stronger than you might think

War, inflation and higher rates were expected to derail America. But has the market got it wrong? Three forces are driving the economy beyond expectations, revealing implications for stock prices and portfolio positioning.

Gold

How much trust is in your portfolio?

Everyone talks about diversifying assets. Far fewer think about diversifying trust. As inflation, debt and market assumptions collide, the question is whether portfolios need greater protection from unexpected outcomes.

Retirement

Retirement in reality - 7 months in

Seven months into retirement, I'm still uncovering surprises. This month was spent reflecting on the slow pace of health change, the myth of neatly scheduled part-time work and the unexpected persistence of retirement guilt.

The new geography of technology leadership

The next chapter of technology may not belong to the companies or business models many expect. As the landscape shifts, some opportunities are emerging in places that remain surprisingly overlooked by global markets.

Sponsors

Alliances

  • ASA-Logo-RGB-ActiveGreen-web.png

© 2026 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.