My colleagues at Ultumus reported last week that BMO in Europe — a relatively new player in the ETF space — are planning to list three new funds on the London stock exchange: Enhanced Income UK, Enhanced Income EU & Enhanced Income US , tickers ZWUK, ZWEU, ZWUS.

My sources suggest that the afore mentioned funds might not actually hit the market for a few months yet but the idea behind the range of funds looks interesting. The core idea is something called ‘enhanced income’. This sounds a lot like an existing idea already in use within mainstream unit trusts provided by the likes of Fidelity and, crucially, Schroders. The latter UK asset manager has long had a very successful fund called the Schroders Income Maximiser fund. First established back in 2005 this was in effect the first stab at building an ‘extra strength’ equity income strategy. Last time I looked the fund had over £1 billion in assets.

The idea of equity income isn’t remotely new. Take a basket of big, reliable blue chips, run a screen which focuses on high yielding stocks with decent balance sheets, and then build an active overlay where the manager looks at the balance sheet strength of the firm and the quality of its earnings growth.

It’s what propelled many an active fund manager to corporate success, not least a certain Mr Neil Woodford. But Schroders decided to go one better, influenced by ideas first coming out of the structured product space.

Why not increase that income yield by using sensible options to increase yield. Here’s Schroders own description of their strategy.

“The fund aims to provide income and capital growth. The fund aims to deliver a target income of 7% per year but this is not guaranteed and could change depending on market conditions. At least 80% of the fund will be invested in shares of UK companies. The fund has no bias to any particular industry or size of company. The fund invests in ‘value’ stocks — those whose share prices appear low relative to their long-term profit potential, and which are typically paying an attractive and growing dividend. The fund generates its income from two sources; dividends received from shares in companies; and cash received from selling some potential future growth of the fund’s holdings using derivatives. The fund may also invest in other financial instruments and hold cash on deposit. Derivatives will be used to achieve the investment objective and to reduce risk or manage the fund more efficiently. The strategy will typically underperform a similar portfolio without derivatives in periods when the underlying stock prices are rising, and outperform when the underlying stock prices are falling.”

Schroders then goes on to specify exactly where it gets its income flows from: The two sources of income are

“1. The natural income provided by company dividends Our fund managers invest in a well diversified portfolio of company shares with a target of achieving an annual yield of around 3 ½%.

2. A tested “covered call option” income enhancement strategy Many financial institutions are willing to enter into contracts relating to individual shares whereby they agree to provide an upfront payment in exchange for any rise in the share price above a certain level over a set period of time. These are known as “covered call options”, which are categorised as “derivatives”. Our fund managers sell these option contracts on a recurring basis, typically for three month periods. The upfront payments from buyers are used to help boost the natural annual dividend by around a further 3 ½%.”

Yep, it’s the good old covered call strategy rewritten for the modern age. The net effect is that investor’s in the fund get 7% per annum from a concentrated portfolio of 36 stocks. Overall returns form the fund have been fairly pedestrian: the return over 5 years is 79% (the benchmark produced 77%) while over 10 years that return hit 76% (71% for the benchmark). But in some respects, as long as the fund kept up with the main market, that’s all that investors cared about. What they really want is that 7% target income yield.

If we look over at the structured products market, that 7% return sounds about right. Investors willing to take some equity risk seem to be feel that a 6 to 8% income return is a sensible trade off. What’s clever about the Schroders Income Optimiser range is that it gives you all the equity exposure you need plus that essential income return.

So, given the success of this retail orientated fund, it’s not surprising that the ETF market in Europe has finally woken up to the marketing potential. Over in the US there are seven covered call — aka known as buy write strategy– ETFs according to www.etfdb. You can see all seven here — The biggest fund, from Powershares, ticker PBP, has just under $300m in assets and has distributing a yield of 3.14%. TERs are around 0.75% which is well below the fees charged by Schroders here in the UK — the institutional AMC is 0.91% while retail clients pay 1.66%. Our guess is that the BMO funds will probably look a lot like a cross between these covered call funds and the Schroders fund (which is a bit more concentrated in its portfolio holdings than the equivalent ETFs). If we had to guess, we’d suggest an income yield of at least 4.5% in the UK must be a target for the BMO fund if not higher.

One caution. Covered call or enhanced income funds have been tried in the UK listed market before. Many years ago, BNP Paribas via its wealth management business Harewood ran a UK Higher Income closed end fund which utilised covered calls to enhance income — a US version of the fund was also launched. Matters didn’t end well as volatility blew up and returns fizzled. Both funds were closed after a while with more than few annoyed wealth manager clients. The key seems to be how actively one runs the options part of the fund — a rather awkward question for a passive ETF fund manager.