This is the second in a series of articles discussing which equity based high yielding Closed-End funds (CEFs) offer investors good value and which equity CEFs investors should avoid based on my analysis. My first article, which you can read here, Part I, essentially pointed out that it has been difficult for the vast majority of equity CEFs to keep up with the soaring broader market averages, but that CEFs can still offer alpha performance opportunities right now if you know where to look.
Part I focused on funds which could see distribution and yield increases heading into 2014, whereas in this Part II article, I will focus on funds that can excel dependent on which direction the market goes from here. I will first start with funds that are attractive in a more difficult market environment since, after the run we have had in 2013, a flat to even down market environment would not be unexpected heading into 2014.
What If We Are Near A Market Top?
I'm hearing more and more from small investors wanting to take on more and more risk as the markets climb ever higher. This to me, is one of the biggest contrarian indicator red flags I can think of. So if we are nearing an interim market top, which equity CEFs offer the best investment opportunities?
Now if the markets begin a correction, which some argue is long overdue, all equity CEF market prices will turn down as well. But what you want to do is start accumulating or adding to positions in the most defensive CEFs that have proven to be able to sustain their Net Asset Values (NAVs) in such a market but can also bounce back when a more negative market environment or even a bear market is over.
In my analysis, no equity CEF is better at doing that than the Eaton Vance Tax-Managed Buy/Write Income fund (NYSE:ETB). ETB has long been one of my "must-own" equity CEFs through all market environments and there's a good reason for that. ETB is sort of an S&P 500 index fund, owning nothing but large cap US stocks, but also selling S&P 500 index options against 95% of its stock portfolio.
Only a few CEFs sell that high of an option coverage and that brings in an enormous amount of option premium into the fund which can largely offset portfolio depreciation during negative market periods. As a result, ETB is very defensive. But its option strategy is not designed to keep up with a market that goes straight up. It's designed to smooth out NAV total return performance no matter what the market is doing.
For example, take the financial crisis bear market of 2008. The table below shows ETB's total return NAV performance compared to the SPDR S&P 500 ETF (NYSEARCA:SPY) from the last market top around the 3rd quarter of 2007 through the bear market which bottomed around the 1st quarter of 2009.
Here you can see that ETB's NAV held up dramatically better during the financial crisis of 2008 compared to the S&P 500, as represented by SPY which includes dividends (i.e most quoted S&P 500 returns don't even include dividends). And take a flat S&P 500 year like 2011, when the markets were essentially down a bit and ETB's NAV was actually up 6.4% on a total return basis.
Now I'm not saying the markets are headed for a fall or will even be negative next year but this is what you can expect from ETB's NAV if that happens. On the other hand, there's a price to pay if the markets go straight up. If the markets soar, like they have in 2013, you give up some of that NAV appreciation potential for the fund's defensive option positioning. This is how the fund smooth's out its NAV performance no matter what the market is doing. YTD, ETB's total return NAV performance is up only 14.6% compared to the S&P 500, up 25.9%. And ETB's total return market price performance is even worse, up only 11.7% YTD. All performances as of 11/12/13.
Not very exciting and it's been a very average year for ETB, but here is where it gets better. ETB typically trades at the highest valuation of any of the Eaton Vance option income funds and it is one of only two Eaton Vance option income funds, EOS being the other, that has traded at premium valuations for extended periods of time. This is shown in the following Premium/Discount graph of ETB since its inception in April of 2005.
Except for the financial crisis period of 2008 and from 2011 until early 2012 when many option-income CEFs were cutting distributions (ETB cut once in early 2011), ETB has pretty much traded close to par if not a premium valuation. Currently, ETB trades at an -8.8% discount which is wider than many of the other Eaton Vance option income funds right now. That is very unusual.
This for a fund which has seen its NAV outperform the S&P 500 on an annualized basis since inception, up about 8% annualized since 2005 compared to the S&P 500 up 6.3% annualized.* Yes, ETB's NAV won't capture all of the upside in a year when the S&P 500 is up 25% or more, but bring that appreciation down to a more normalized percentage or flat or even a down S&P 500, and ETB's NAV will outperform.
* Source: Eaton Vance Semi-Annual Report dated 6/30/2013
Of course, ETB's market price can go anywhere investors take it but I believe ETB's current market price at $14.59 and a -8.8% discount to its $16.00 NAV (as of 11/12/13) is very attractive right here, right now. One of the biggest reasons is that Eaton Vance has a 10% share buyback program in place for all of its option-income funds and ETB is the only fund which has not bought back ANY of its shares yet, at least as of October 4th when the last buyback update was given by Eaton Vance. That is a huge amount of support for ETB's market price if the markets really go negative and ETB's discount widens to say, double-digits.
Second, ETB is the smallest of the Eaton Vance option-income funds at $395 million in assets and can make the largest market price moves when a buyer steps in. And third, ETB offers a conservatively managed 8.9% market price yield paid monthly, much of that tax-advantaged because much of the distribution is categorized as Return-of-Capital (ROC). ETB is one of the Eaton Vance option-income funds that specializes in tax-advantaged ROC distributions. If you don't understand how option-income CEFs can specialize in Return-of-Capital distributions, I have written many articles on the subject, the first all the way back in January of 2011, Is ROC As Bad As It Sounds?
For more information on ETB, go to this link, Eaton Vance ETB. ETB goes ex-dividend next Wednesday, November 20th.
Other CEFs For A Near Market Top
I should also mention that there are even more defensive option-income CEFs for those investors who feel we are nearing a market top but want to continue to receive income from their investments.
One that I like that is more technology focused than ETB - even though ETB includes Apple (NASDAQ:AAPL), Google (GOOG) and Microsoft (NASDAQ:MSFT) in its top 10 holdings - is the Nuveen Equity Premium Advantage fund (JLA). JLA sells S&P 500 and NASDAQ-100 index options against 100% of its all US large cap stock portfolio in out-of-the-money to even in-the-money options. In-the-money options means that the fund is even more defensive than a fund like ETB which sells slightly out-of-the money options.
As a result of this very defensive option sleeve, JLA's NAV is only up 11.9% YTD, a far cry from the NASDAQ composite, up 27.3% YTD or the S&P 500. But if the NASDAQ and S&P 500 are nearing a top and start to turn more flat to even negative, JLA's NAV will hold up much better and start to narrow the gap. At a historically wide -12.1% discount, a 9.2% market yield (quarterly pay), JLA offers an excellent risk/reward.
Keep in mind that even the most defensive option-income CEFs can see their market prices initially sell off in a down market environment because investors tend to want to hold onto their best performing CEFs and sell their laggards first. This is one of the more counter-intuitive reactions you'll see from CEF investors but this is also where opportunities are created. In other words, be prepared to add to positions if we go into a more negative market environment.
In the next article, I will next go over some equity CEFs I like if the markets continue their bullish upward trajectory. I cannot predict where the markets go from here, but I can certainly point out funds to investors to take advantage of no matter where the markets go in 2014.
Disclosure: I am long ETB, JLA, SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.