Written by Nick Ackerman, co-produced by Stanford Chemist
The Eaton Vance Diversified Tax-Managed Equity Income Fund (ETY) delivered strong results for its shareholders. An increase in distribution until 2021 based on these results. Their strategy is quite simple, despite the confusing names of the Eaton Vance funds. Once you have a basic understanding of these funds, you can begin to see the nuances between them.
In this case, ETY is similar to Eaton Vance Tax-Managed Buy-Write Income Fund (ETB). They both write calls against the S&P 500 index and compare themselves to this same index. However, ETB aims for an option overlay of nearly 100% of the notional value of the underlying portfolio. ETY is only sticking to a target of around 50%.
In theory, the crushed ETY lower target should allow the fund to perform relatively better than ETB during rapid market rises. There will be less losses generated due to the cash settled calls they have written. However, this would all depend on whether they have the exact same wallet. They don’t.
Instead, ETY has a more concentrated total of 56 holdings, and ETB has 169 holdings as of the last update provided. So, despite what should happen in theory, in practice the different farms could also influence the result. With that caveat, over the past 10 years we’ve seen ETY outperform quite significantly. Just the result we should expect from a raging bull market that didn’t really end, but very briefly in 2020, since 2009.
On the other hand, we could see ETB outperform in mostly flat markets or those that only decline moderately. We have noticed that ETB is holding up a little better during panic selling. The idea is that they generate more return on options expiring worthless as the market moves without direction (i.e. their portfolio does not generate positive or negative returns). Unfortunately, our last bear market was so quick from top to bottom and back to bull market mode that there wasn’t enough time to see it play out.
Below is the performance between February 19, 2020 and March 23, 2020. This marks the peak to trough of market panic selling in 2020. They are coming out essentially the same, with ETY actually selling very slightly to a lesser measure. The differences are subtle and could also stem from their different holdings.
- Z-score over 1 year: 1.03
- Premium: 3.31%
- Distribution yield: 7.59%
- Expense ratio: 1.07%
- Leverage: N/A
- Assets under management: $2.212 billion
- Structure: Perpetual
ETY is a fairly straightforward fund at first glance; the fund’s policy is “to invest in a diversified portfolio of domestic and foreign common stocks with an emphasis on dividend-paying stocks and to buy (sell) call options on the S&P 500 Index on part of the value of its common stock portfolio to generate cash derives from the option premium received.” Their objective with this strategy is to “provide current income and gains, with a secondary objective of capital appreciation”.
Although they mention foreign equities, they ultimately hold most of the big US names you’d expect. They note having 0.97% in Asia/Pacific in their latest fact sheet, and that is the extent of their foreign holdings.
These investments emphasize qualified dividends and generate long-term capital gains, making them more tax efficient. Along with their options strategy which can create losses, return of capital also forms a significant part of their distribution classifications in most years. It is a way of deferring tax obligations.
The fund is quite large, which generally provides plenty of liquidity for investors to enter and exit. The fund expense ratio of 1.07% is also lower for closed-end funds. This is a plus point when it comes to generating returns.
Performance – Solid returns
Thanks to the bull market that provided many returns for equity funds, ETY also benefited enormously from these gains. Going back to one of the standard timelines, we’re seeing strong results.
In 2021, the fund produced a return of 23.39% based on a total net asset value return, with its underlying portfolio. However, the market price had behaved even better. This wasn’t all that unusual for the year, as rebates across the board tightened for closed-end funds. This pushed ETY to high 10-year premiums.
The higher bounty is something I noted in my June 2021 update, and it has yet to resolve. As long as equity markets remain strong, I suspect these historically unprecedented premiums will persist.
This puts it in a situation where it is a very successful fund. Still, those not already holding may not want to rush, instead using a dollar cost averaging method to build a position over time.
Distribution – Boost was welcome
Following my June update, Eaton Vance announced payout increases for several of their funds. ETY has proven to be one such fund with a distribution that has grown from $0.0843 to $0.0929 per month, an increase of 10.2%.
Of course, this is explained by the strong results of the stock market as a whole. This last payment is equivalent to a distribution rate of 7.59% and a NAV yield of 7.84%.
Net investment income (“NII”) fell quite significantly during the year. However, the realized gains and unrealized appreciation were more than enough to offset this to cover their distribution. They paid out a total of $157,942,483 to shareholders in 2021. This brings NII coverage to just 5.22%.
We can also see that thanks to the fund’s premiums, they sold new shares through their market offering. New shares are also created through the dividend reinvestment plan they offer.
The fiscal character reflects some of what we see above. 2020 showed primarily return of capital, but 2021 also contained a fairly significant classification as capital gains as they realized gains significantly. The table below also helps to highlight just how much things can change from year to year. That being said, generally this fund may be appropriate for a taxable account.
The reason for the return of capital here comes down to its option writing strategy. It may generate losses due to cash settlement. You cannot directly own an index, but you can own its underlying holdings. This means that when the index rises, losses will be generated on the options side of the equation, but the underlying holdings offset this negative drag. For their 2021 fiscal year, the realized losses caused by their options were approximately $44.2 million.
On the other hand, if the underlying holdings are not moving much, it should mean that the index is not rising that much. Thus, they simply collect the premium and generate enhanced returns that way.
We haven’t seen a stable market for this in quite a while, which is one of the reasons why write-call funds are often dismissed as underperforming funds. It just wasn’t their time to shine. Not sure if this will ever be their moment to shine either, but just something to consider. For income investors, return of capital can be beneficial to defer tax obligations. It reduces an investor’s cost base, which means there is no tax until it is sold – under current tax law.
The fund’s portfolio rate was 36% for the prior year. It was the lowest in the last 5 years, but it was still modestly active. It reached 75% in 2017. As of October 31, 2021, technology was the largest sector represented in this fund, as is typically the case with most such Eaton Vance options-based funds.
The top ten stocks are also what we expect from most of their option-based funds. As mentioned earlier about the high concentration of the portfolio, the top ten account for nearly 40% of the fund.
Some notable things here might be the lack of meta platforms (FB). It is generally a basic element in all the portfolios of these funds. It’s not even an exploit if you dig deeper into their entire list of exploits – at least not at the time of this report. It could be now, or between reporting periods they could sneak into the post.
I also think that Intuit (INTU), Danaher (DHR) and Eaton (ETN) are interesting names that appear in this fund. They are more unique than what we usually see and help differentiate the fund a bit.
However, I would also point out that they were in the fund earlier this year. It would seem that due to the appreciation they have now increased their allowances. These positions saw the number of shares held in ETY rise from their January levels to the October annual report.
In particular, it would seem that the INTU did very well. These three positions outperformed the broader S&P 500 Index with their performance from January 1, 2021 through October 31, 2021. The S&P 500 Index is represented by the SPDR S&P 500 ETF (SPY).
INTU is a technology stock that provides software services to almost everyone. DHR is a healthcare company operating in the life science tools and services industry. ETN is an industrial sector stock supplying electrical components and equipment.
These are three new positions in the fund’s top 10 that did not previously appear when we last visited the fund.
ETY continues to be a strong performer in the Eaton Vance lineup of funds, which is what we expect with this basket of CEFs. This is precisely why Morgan Stanley (MS) should continue to let them operate independently and under their own brand. The saying, “if it ain’t broke, don’t fix it”, comes to mind.
The increase in distribution at the start of 2021 was a welcome increase. This was mainly due to the significant appreciation the fund has had over the past few years now. Gains going forward might be harder to come by, but their option writing strategy might play a bigger role if we get a more temperate market.
Unfortunately, the fund is at record valuations based on its current premium. This puts him in a position where averaging the dollar cost in the name might make more sense, rather than investing in a full position at the moment.