September 30, 2020
The Search for Income: Income the Right Way
September 30, 2020
The Search for Income: Income the Right Way
September 30, 2020
Portfolio managers from the International Equity Team discuss dividends in the current environment and Morgan Stanley Investment Funds (MS INVF) Global Brands Equity Income Fund.
Can you provide a brief overview of the Fund?
RICHARD PERROTT (RP): The MS INVF Global Brands Equity Income Fund invests in a portfolio of stocks in line with that of the MS INVF Global Brands Fund, as well as employing a conservative option strategy. It seeks to provide investors with attractive and sustainable income alongside long-term compounding of capital and relative downside protection.
What differentiates the fund?
BRUNO PAULSON (BP): Many traditional products that focus on income do so at the expense of poor compounding of capital. With the MS INVF Global Brands Equity Income Fund, we seek to offer our clients access to our established Global Franchise investment process and strategy—with its 24 year1 track record of successful investing in high-quality companies—while at the same time generating an enhanced income component.
The Fund seeks to provide an attractive yield while still offering potential capital appreciation and a measure of downside protection. It generates income from a combination of dividends from high-quality stocks and call option premiums. We would argue ours is “income, the right way”, as it offers sustainable dividends in addition to compounding of capital; the focus of our stock selection is investing in long-term compounders.
The overall Fund is managed by the highly experienced and well-resourced International Equity Team, while the systematic call option overwrite is run by our Solutions & Multi Asset Team, specialists in the implementation of option strategies.
1The Global Franchise strategy has a 24-year track record, starting at inception 31 March 1996. The MS INVF Global Brands Fund has a 20-year track record, with an inception date of 30 October 2000.
How are traditional income and high dividend funds faring in this tougher economic environment?
BP: It’s being described as a dividend drought or an income squeeze, as companies fail to - or choose not to - pay their dividends for political, moral, logistical or financial reasons.
We believe our portfolio’s high-quality bias offers a far more robust approach to income generation than funds that historically provided higher yields but generated poor returns relative to the benchmark. We focus on the underlying company fundamentals and free cash flows, which in turn means dividends are more likely to be sustainable and growing. The companies in the Global Brands Equity Income Fund make a high return on capital and are capital light, this means they can afford to pay out, and keep paying out, dividends to shareholders. This is high quality income. The overwrite enhances this yield.
Can you expand on the income generation component?
DIRK HOFFMANN-BECKING (DHB): We use a systematic options overwrite strategy developed by Morgan Stanley Investment Management’s Solutions & Multi Asset Team to generate income which, in addition to the dividends generated on the underlying equity portfolio enables us to achieve a current target total yield of 4% p.a., subject to market conditions.
We sell short-term index call options on six liquid global indices, which earn premiums. We decided to sell call options on indices to maintain the individual stock level exposure of the portfolio; this also removes the possibility of any conflicts of interest between the stocks and the options. In addition, we view the trading of individual stock options as potentially costly, as they are less liquid than index options. The conservative design of the overwrite is in keeping with the capital protection characteristics for which the team’s funds are known; we do not sell equity index puts, which may compound losses when markets fall.
We have sought to minimize the cash drag that option strategies often create. A typical income investment strategy requires holding a high level of cash to back the options they sell, typically up to 20% of a portfolio. As a result, equity income products typically underperform on the capital growth side, as a result of cash drag. Because the options overwrite is uncollateralized, when our clients invest in this Fund, their capital is invested in the underlying equity portfolio and not posted to counterparties. In the event of counterparty risk, the only funds at risk are option premiums potentially owed by the counterparty. Note that in the underlying equity we typically maintain a cash allocation of 2-3% irrespective of the overwrite.2
How do you manage risk? Are there specific controls in place to limit loss?
RP: We think about risk management in exactly the same way as we do for the MS INVF Global Brands Fund. We consider absolute risk—the chance of losing money—integral to our stock selection process.
With regard to our use of call options, there are a number of risk controls we have in place. We focus on short duration, “out of the money” options, the use of which allows us to limit call-away risk. We sell short-dated options to ensure that the embedded value of the options is modest.
We believe that in most normal market scenarios, the Fund is likely to deliver positive absolute returns. When markets fall, we continue to receive income from the options strategy, so the overwrite is in keeping with the asymmetric return profile that Global Brands has historically delivered. While the Fund may give up some upside during rising markets, it may provide some cushioning during market downturns. We only sell index call options, hence the Fund may experience call away on options when the market has gone up significantly; in that situation the Fund is likely to post an overall gain, although it may underperform the market.
We execute our overwriting process on a daily, rather than monthly, basis. Monthly options are more susceptible to adverse market movements as there is no flexibility to adjust the strike price in response to changes in market volatility. And the overwrite is global— the geographical diversification offered by the index options sold means the Fund may benefit from the fact that individual equity markets can behave differently to one another.
Source: Morgan Stanley Investment Management.
Past performance is not a reliable indicator of future results. Returns may increase or decrease as a result of currency fluctuations. All performance data is calculated NAV to NAV, net of fees, and does not take account of commissions and costs incurred on the issue and redemption of units. The value of the investments and the income from them can go down as well as up and an investor may not get back the amount invested. There are additional risks involved with this type of investment. Performance returns reflect the average annual rates of return. Periods less than 1 year are not annualised. Performance returns are compared to the MSCI World Net Index and are considered to be a relevant comparison to the portfolio. Comparisons of performance assume the reinvestment of all dividends and income. The inception date of the MS INVF Global Brands Equity Income Fund ZR Class is 29 April 2016.
What type of investor may find this Fund attractive?
DHB: The Fund is a good fit for investors looking for a steady, reliable source of income, or who require a higher level of income than that supplied by core equity funds, while seeking a good balance between income and potential for capital growth. Distributions are made quarterly3. It may also appeal to investors seeking a potential cushion during down markets, or who are prepared to forego an element of upside potential in rising markets in order to receive a defined income. It may be attractive to those who seek diversification away from traditional yield-maximizing income strategies which are tilted towards financials, utilities, materials, energy and telecommunications. And, of course, it’s a natural fit for investors who are familiar with the high-quality characteristics of the Global Brands Fund and seek a source of sustainable income built on robust fundamentals.
3 Applicable to distributing share classes. An R suffix in the name of a share class denotes a distributing share class. The Company intends to declare dividends which will be set at the discretion of the Directors. Such share class may pay distributions from capital or may charge all or part of the Fund’s fees and expenses to the capital of the Fund. Dividends paid out of capital may result in an immediate decrease of the Net Asset Value per Share. For further details, please refer to the offering document of the Fund.
There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market value of securities owned by the portfolio will decline. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this strategy. Please be aware that this strategy may be subject to certain additional risks. Changes in the worldwide economy, consumer spending, competition, demographics and consumer preferences, government regulation and economic conditions may adversely affect global franchise companies and may negatively impact the strategy to a greater extent than if the strategy’s assets were invested in a wider variety of companies. In general, equity securities values also fluctuate in response to activities specific to a company. Investments in foreign markets entail special risks such as currency, political, economic, and market risks. Stocks of small-capitalization companies carry special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed markets. Non-diversified portfolios often invest in a more limited number of issuers. As such, changes in the financial condition or market value of a single issuer may cause greater volatility. Option writing strategy. Writing call options involves the risk that the Portfolio may be required to sell the underlying security or instrument (or settle in cash an amount of equal value) at a disadvantageous price or below the market price of such underlying security or instrument, at the time the option is exercised. As the writer of a call option, the Portfolio forgoes, during the option’s life, the opportunity to profit from increases in the market value of the underlying security or instrument covering the option above the sum of the premium and the exercise price, but retains the risk of loss should the price of the underlying security or instrument decline. Additionally, the Portfolio’s call option writing strategy may not fully protect it against declines in the value of the market. There are special risks associated with uncovered option writing which expose the Portfolio to potentially significant loss.
The MSCI World Net Index is a free float adjusted market capitalization weighted index that is designed to measure the global equity market performance of developed markets. The term “free float” represents the portion of shares outstanding that are deemed to be available for purchase in the public equity markets by investors. The performance of the Index is listed in U.S. dollars and assumes reinvestment of net dividends. The index is unmanaged and does not include any expenses, fees or sales charges. It is not possible to invest directly in an index.
Free cash flow is cash flows (net income plus amortization and depreciation) minus capital expenditures and dividends.
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