Covered call strategies have been around for many years and are particularly well known in the US market. As yields on financial assets have diminished, the popularity of these strategies has surged, by as much as 25 per cent per annum over the past 10 years according to some estimates, and some $45bn is currently invested. The approach is less accepted in the UK, but a handful of equity-focused funds are managed in this way. A covered call position involves taking a long equity position and writing a call option on the same security. In essence, some of the future potential capital growth is sold in exchange for an option premium. During bull markets, share prices may go through the pre-set strike price of the options, and the positions can be called away; such strategies will typically lag the market's advance. In down markets, the strategies are exposed to declines in share prices, but the revenues generated by call writing mitigate the drawdown.

There is some debate as to whether the option premium should be considered as income or a capital enhancement. Virtually all UK domiciled funds treat the cashflows as income. As a result it is possible for an equity fund to boost distributions by approximately 3 per cent to 4 per cent on top of any dividend income. Critics of the approach highlight the disadvantageous tax treatment that these enhanced distributions will suffer. This seems a valid concern, but the withholding tax is relatively modest and something that affects any dividend-focused strategy. It is noticeable that dividend-focused strategies have managed to overcome this tax handicap and have generally delivered superior returns.

A further concern is that the high distributions may not be sustained over the long term. This can certainly be the case when the strategy is applied aggressively, but most funds in the UK retail market adopt sensible overwriting policies. There are two funds dedicated to the strategy listed within the Square Mile Academy of Funds: the Schroder Income Maximiser and the Fidelity Enhanced Income funds, and both are focused on UK equities. The Fidelity Enhanced Income fund aims to generate an income that is 50 per cent to 100 per cent higher than the FTSE All Share index. The managers believe that this sort of dividend distribution can be generated while maintaining the real value of the capital. The fund was launched in 2009 and over this period the capital value of the fund has indeed broadly grown in line with inflation.

The Schroder Income Maximiser fund is run with a 7 per cent yield target. The equity portion of the fund is run by the same managers behind the Schroder Income fund, Nick Kirrage and Kevin Murphy. The option strategy is overseen by Thomas See and this aims to bring the yield up to 7 per cent. While not an explicit objective of the fund, the managers feel that this sort of distribution level is consistent with total long-term equity returns and it should be possible both to maintain this level of distribution and the nominal value of capital. Over the fund's 10 year life, this has been achieved.

Over an extended time period, a traditional portfolio is likely to generate a higher total return than a similar portfolio that has an option overwriting strategy applied. However, the performance difference is unlikely to be too great and we would expect the covered call strategy to be noticeably less volatile than the traditional approach. The strategy adds a short volatility component to the portfolio and this is a useful diversifier that is not easy to reproduce in a cost-effective manner. Covered call approaches tend to generate attractive Sharpe ratios as a result.

We believe that such equity strategies have a useful role to play for advisers looking for solutions for income-hungry clients in retirement. The volatility of the approach will exceed fixed income strategies but should represent a lower risk way to play equity markets. Care should be taken to understand fully the nature of the risk-reward payoff that these strategies involve and the meager shelter that they provide during sharp market downturns.