Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 201

Not all equity income funds are the same

The equity income sector continues to grow as historically low interest rates globally means investors are hunting for yield. Not all equity income funds are the same and investors should be aware of the equity exposure a fund is taking to generate income. Investors need to consider their objectives and ongoing requirements, as taking on too much risk at the wrong time can prove disastrous.

Any assessment of the equity income space and products should identify traditional equity managers who invest in long-only dividend-builder type funds and generally have up to 100% exposure to equity markets. Generally, these consist of a portfolio of Australian shares that deliver dividend income plus franking credits and capital growth over the long term. Investing in shares for income works best if company dividends are sustained and growing. However, dividend growth isn’t guaranteed in the face of falling profits and dividends alone might not meet an investor’s need for income.

The use of options

It is important for investors who intend to use their shares as sources of income to consider other ways of earning income in addition to dividends and franking credits.

Over the past few years, we have seen the emergence of equity income funds which apply an option or risk overlay to enhance income and reduce the exposure to equity markets. These funds generate additional income by selling call options over the shares held in the portfolio.

The benefits of options are threefold:

  • to generate income from option premiums
  • to manage the fund’s exposure to the share market
  • to reduce volatility and downside risk.

Maximising income

So how does it work in practice? To generate enhanced income, the fund buys a stock and sells a call option over that stock whereby the fund receives:

  • any dividend paid during the period
  • the option premium
  • any franking credits associated with the dividend payment.

Call options 101

A call option gives the holder the right, but not the obligation, to buy a stock at a specified price (known as the strike price) within a specified time period.

  • Buying a call option

    When you buy a call option you buy the right to buy the stock at the strike price. You pay a premium for this right.

  • Selling a call option

    When you sell a call option you earn a premium. In return for this premium you have the obligation to sell the stock at the strike price if the buyer asks you to.

The following example provides more information on call overwriting strategies:

Starting share price = $100

Strike price = $110

Option premium = $2

If the share price falls, stays the same or rises but stays below the strike price of $110:

  • The seller of the call option has earned a premium.
  • The call option is worthless to the buyer as they can buy the shares for a lower price on the share market.

If the share price goes above the strike price, say up to $115:

  • The buyer of the call option can make a profit (less the premium paid) by buying the shares for the strike price of $110 and then selling them in the market for $115.
  • The seller of the call option has earned a premium of $2 and has also made a gain on the shares of $10 (the difference between the strike price and starting share price). However, if the option is exercised they will have to sell the share at the strike price, forgoing the extra $5 per share.

Managing exposure to equity markets

An equity manager that uses call overwriting to enhance income and reduce risk typically has an equity exposure of 60 to 80% of equity markets. The emergence of a new type of equity income fund that incorporates an index hedging strategy in addition to its call overwriting strategy provides an alternative as risk is often further reduced to 50% exposure to equity markets.

A useful way of comparing the risk of differing investment opportunities is to examine how each performs in a stress-testing environment. For instance, if we stress test an equity portfolio for a fall of -10% in the equity market, most equity funds with the same volatility and risk profile of the index and will perform in line with this move downwards.

An asset manager that dramatically reduces this risk through hedging and call overwriting could have outperformed this benchmark significantly (by up to 6.34%). Although investors can’t totally avoid exposure to adverse market conditions (unless 100% invested in cash), a smaller exposure to negative returns avoid erosion of capital and a swifter recovery. Drawdowns are a useful way of comparing funds over time. Avoiding large drawdowns in down markets helps investments recover.

The GFC was a clear reminder that risk is equally important as returns. Recent market shocks like Brexit and doubts about the strength of the global economy (in particular, China) should encourage the conservative investor to focus on risk-adjusted returns. The fact that the VIX volatility index is at its lowest level since 1993 and corporate bond spreads have rallied strongly this year suggests a high degree of complacency has crept into market.

Conservative investing requires a balance between goals: too little risk means savings could be eaten away by inflation and too much risk could result in volatile returns which have the potential to destroy capital. Understand which equity income fund meets your needs.

 

John Moore is a Portfolio Manager at Omega Global Investors, a global boutique fund manager. This article is general information and does not consider the circumstances of any individual.

 

banner

Most viewed in recent weeks

Raising the GST to 15%

Treasurer Jim Chalmers aims to tackle tax reform but faces challenges. Previous reviews struggled due to political sensitivities, highlighting the need for comprehensive and politically feasible change.

7 examples of how the new super tax will be calculated

You've no doubt heard about Division 296. These case studies show what people at various levels above the $3 million threshold might need to pay the ATO, with examples ranging from under $500 to more than $35,000.

Are franking credits hurting Australia’s economy?

Business investment and per capita GDP have languished over the past decade and the Labor Government is conducting inquiries to find out why. Franking credits should be part of the debate about our stalling economy.

Here's what should replace the $3 million super tax

With Div. 296 looming, is there a smarter way to tax superannuation? This proposes a fairer, income-linked alternative that respects compounding, ensures predictability, and avoids taxing unrealised capital gains. 

The rubbery numbers behind super tax concessions

In selling the super tax, Labor has repeated Treasury claims of there being $50 billion in super tax concessions annually, mostly flowing to high-income earners. This figure is vastly overstated.

9 winning investment strategies

There are many ways to invest in stocks, but some strategies are more effective than others. Here are nine tried and tested investment approaches - choosing one of these can improve your chances of reaching your financial goals.

Latest Updates

Taxation

100 Aussies: seven charts on who earns, pays, and owns

The Labor government is talking up tax reform to lift Australia’s ailing economic growth. Before any changes are made, it’s important to know who pays tax, who owns assets, and how much people have in their super for retirement.

7 key charts on the state of the Australian property market

The Australian property market stirs fierce debate - often bullish optimism versus crash predictions. But beyond the noise, seven charts reveal what's really driving prices and the outlook for residential real estate.

A simple alternative to the $3 million super tax

Division 296 aims to introduce improved fairness into the superannuation system, yet is overly complex. This scours the world for better ideas and suggests a simpler alternative which can achieve the same goals.

CBA and the index conundrum for super funds

After the hyperbolic rise in CBA shares, super funds are floating the idea of carving out the weightings of ASX bank securities and indexing them within their portfolios. This looks at why that might be a big error.

Strategy

10 policies to drive Australian productivity higher

Here's a comprehensive list of proposed reforms to fix Australia's stagnating economy, including introducing a flat income tax rate, reducing migration, and making childcare tax-deductible.

Interviews

Where to find big winners in Asia

As more money looks for a home outside the US, Asia may soon get some love. Fidelity's Anthony Srom outlines the best places in Asia to invest, including in Chinese consumer names, Indian financials, and Thailand.

Investment strategies

We have trouble understanding the time value of money

We overvalue the present and underestimate the future - it’s a cognitive glitch called hyperbolic discounting. It affects savings, spending, and loans, and it's more common - and costly - than we think. 

Sponsors

Alliances

© 2025 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.