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

Little‑known government scheme can help retirees tap into $3 trillion of housing wealth

The Home Equity Access Scheme in Australia allows older homeowners to tap into their home equity for retirement income, yet remains underused due to lack of awareness and its perceived complexity.

Origins of the mislabeled capital gains tax ‘discount’

Debate over the CGT discount is intensifying amid concerns about intergenerational equity and housing affordability. This analysis shows that the 'discount' does not necessarily favor property investors.

2 billion reasons to fix retirement income

A proposal to address Australia's 'stranded balances' in retirement by requiring super funds to transition members to pension phase at 65, boosting retirement income and reframing super as a source of income.

The ultimate superannuation EOFY checklist 2026

Here is a checklist of 28 important issues you should address before June 30 to ensure your SMSF or other super fund is in order and that you are making the most of the strategies available.

Div 296 may mean your estate pays tax on assets your beneficiaries never receive

The new super tax, applying from 1 July, introduces more than just a higher rate on large balances. It brings into focus a misalignment between where wealth sits and where the tax on that wealth ultimately falls.

Do super funds need a massive wake up call?

UK retirement expert, Guy Opperman, believes super funds are failing at supporting members in deaccumulation. Here is what Australia should do about it. 

Latest Updates

Retirement

How inflation is quietly moving the goalposts on retirement

Inflation doesn’t just raise today’s bills - it quietly increases the amount needed to retire, while simultaneously making it harder to save. Three steps to take before June 30th to improve retirement outcomes.

Investment strategies

Three strategies for investing amid AI whiplash

AI fears have shifted from bubble talk to disruption anxiety, driving investors toward asset‑heavy, 'AI‑resistant' businesses while punishing many software and service firms. This environment may be ripe for stock pickers.

Investment strategies

Are private market assets the answer in an unstable world?

Private markets can offer diversification and return potential, but their opacity, scale and wide dispersion of outcomes make manager selection and due diligence critical for non‑institutional investors.

Property

Mispriced in plain site: The case for Global REITs

Global REITs have fallen out of favour, trading at deep discounts after years of underperformance, despite resilient earnings and improving fundamentals.

Investment strategies

Survival is the only success

True financial success isn’t about how much you make, but whether you can sustain it — survival is the only win that matters.

Investment strategies

$42 billion too late

Why Australia's biggest energy bet may already be redundant while a less celebrated government program is exceeding expectations. 

Investment strategies

Do investors accept lower returns from assets that make them feel good?

Assets that deliver emotional satisfaction tend to offer lower financial returns, as investors accept an “emotional yield” in place of performance which shapes how investors approach ESG and unpopular assets.

Sponsors

Alliances

© 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.