A friend who is a fund manager suggested we should look at using derivatives to generate additional income as part of our investment strategies. Can we get some advice on how this works?

Hi Drew,

Thank you for your question.

Unfortunately, this is beyond my qualified area and cannot speak to the matter.

However, as we have access to a Financial Planner at Assured, I will speak with them and see if they can provide assistance on you question.

Regards,

Dino

Hi Drew,

Thank you for your question.

Fund managers tend to use derivatives to create income in portfolios in a number of ways, especially at a time where cash and fixed interest rates are low and the share market is quite volatile. A derivative is a contract between two or more parties who agree to the value of an underlying asset which can include investments such as bonds, shares, currencies, interest rates etc.

Strategies can include the following and will change with each fund manager:

Buying writes and selling put options.
Using Interest rate swaps
Purchasing shares that pay high dividends-
Investing in companies with Franking credits

Using derivatives to create income in a share portfolio is gaining popularity as there are a number of managers who use this approach to aim for a greater income return than your traditional sources. A number of benefits include:

- Reduced volatility

- Greater yields than dividends alone

- Potential franking credits

- Opportunity for some capital appreciation

- Risk management

The main objective of these strategies is to have exposure to a diversified portfolio of shares while paying income on a regular basis. Eg. Selling call options (also called a ‘buy-write strategy’) means the fund is effectively selling some of tomorrow’s possible growth on a stock for an income premium today to reduce volatility. Although the use of derivatives provides extra income, it comes at the expense of capital growth.

In rising market conditions, derivative income strategies have lagged significantly from a total return perspective compared to traditional dividend and franking credit funds. Some may argue that the derivative income strategies tend to hold up pretty well in down markets, meaning they could be used as a supporting player to offer relatively defensive equity exposure.

I hope this helps in giving you an indication of how fund managers use income strategies in their portfolios and I would highly recommend speaking with a Financial Professional about your options and what strategy may work best for you when taking into account your goals and objectives as this area may be a little tricky and it is best to know the advantages/disadvantages of going down this path.

Feel free to contact me on the below details should you require any further assistance.

Ronald Pratap
Principal Financial Adviser
RP Wealth Management
Level 2
351 Oran Park Drive
Oran Park N.S.W 2570
T: (02) 9188 1547
M: 0434 502 079
E: ronald.pratap@rpwealthmanagement.com.au
W: www.rpwealthmanagement.com.au
F: https://www.facebook.com/RPWealthManagement