This article is part of Morningstar's Guide to Investing for Income
Emma Wall: Hello, welcome to this 'Investing for Income Special'. I'm Emma Wall, and here with me today is John Teahan, manager of the RWC Global Enhanced Dividend Fund.
Hello, John.
John Teahan: Hi, Emma.
Wall: So, you have enhanced in the title of your fund. This is because you take a portfolio of shares and then sell call options on the stocks you feel the highest convictional on.
Teahan: Yes. It's very much like a traditional equity fund in the sense that we're looking for stocks that are generating a yield. The portfolio itself yields 3%. But to enhance that toward a target yield of 6%, we sell it call options on the stocks that we hold, and it's that option premium that allows us to, in addition to the dividend to get to that 6% target.
Wall: 6% target is very attractive in the current market, but you did say that you are still managing to get above inflationary returns purely on the equity plays. You've got quite a developed market bias in the fund; despite of being global only one Asian stock, perhaps you could talk to me about the opportunities that you're seeing maybe in the U.S. because that take up 40% of portfolio doesn't it?
Teahan: Sure. So, I guess, just to step back. If you think about what we're trying to do in this environment, we're trying to produce that yield in the context of valuations that we feel across the market are stretched, in the context of other asset classes where the yield is very low. So, investors that are looking to generate a yield are having to take more risk than they previously would have done.
So with our fund what we're looking at doing is looking to invest in stocks that have lower volatility characteristics, and that's what we're finding in developed markets, large or megacap stocks deliver a dividend, but also have lower volatility in terms of their share prices. So that we can return – total return in lower volatility turns along with delivering that 6% yield.
Wall: I think the one concern about developed markets at the moment, is that they are looking a little bit overheated valuation wise. Is that a concern for you, as an income investor? You're not a value investor, but even still. And if so, are there particular sectors that perhaps are looking more attractive with that in mind?
Teahan: Sure, and while we're income investors we're very much focused on valuation because that is such a big determinant of your total returns over time, and yes, we are concerned about valuations in the market. It's obvious with such a massive QE experiment that valuations would become stretched over time.
So, what we are looking at is particular sectors where we still believe that value is offered. So, if you think about the pharmaceutical sector, we see dividend yields there of over 3%. If you think of the yield in the S&P, it's less than 2%, so you can see the pickup based on dividends.
Also if you think of the valuations within those companies, whether they've increased over the last 12 or 18 months, we still believe they offer value over the long-term.
Wall: Of course, having that developed market wise and looking for that sort of securities, in line with what a lot of investors today want – they want a less volatile portfolio. What would then be the trigger for emerging markets in Asia to look attractive for you as an income investor?
Teahan: For Asia, when we think about the yields that are available in Japan, they're not very attractive. And while we can write covered-call options on the stocks, we do want a base dividend within the fund, that is somewhere around 3% level.
We do continually look for opportunities in Asia, in particularly developed Asia, but we haven't, as I said, come across those as yet, and we will add to the portfolio if and when those opportunities arise.
For now, we're very much focused on, as you said the U.S., Europe where we do see some pockets of value within as I said pharmaceuticals, also telecoms, and within the integrated oil companies.
Wall: So, it's very much then about sort of the large quality stocks?
Teahan: Exactly. Because again going back to the point about looking to generate yield. If you think about pre-crisis; investors could get a yield of 4% or 5% on the sovereign bond fund or bond itself with short duration. Today those high grade sovereign bonds are yielding nothing or close to nothing. So they are being forced up the risk curve.
So, we are trying to provide something – a yield, an attractive yield for those investors without taking massive risk and that's what the fund is providing, and that's why we keep those large cap stable companies. So that we can generate those yields and the risk of a drawdown in those type of portfolios is less than the wider market. But we go further than that as well. We're meeting quite a high cash balance at the moment 20%, to give us the opportunity to pick up more companies that we like, but add valuations that we think are more attractive and more reasonable.
Beyond that, we also use put options in the fund, again, to reduce that drawdown potential or volatility. Coming back again to the point that investors who typically could get 4% or 5% from sovereign bond funds have very little opportunities in the market at the moment, and therefore we're giving them at least part of an answer to their problem.
Wall: John, thank you very much.
Teahan: Thank you very much, Emma.
Wall: This is Emma Wall for Morningstar. Thank you for watching.
