Eaton Vance Enhanced Equity Fund: A Different Way to Extract Extra Yield

Jan.29.07 | About: Eaton Vance (EOS)

By Carla Pasternak

Formed last January, the $900 million Eaton Vance Enhanced Equity Income Fund II (NYSE:EOS) invests in over a hundred mid- and large-capitalization common stocks, mostly in the U.S. Top holdings include names like General Dynamics (NYSE:GD), Oracle (NYSE:ORCL), Apple (NASDAQ:AAPL) and Teradyne (NYSE:TER).

The fund writes call options on over half of the stocks in its portfolio and generally doesn't sell puts. It's well positioned to benefit from a rising stock market -- since it writes calls on just a portion of its portfolio, it can enjoy capital gains on the remaining stocks. Since covered calls rely on volatility to generate income, the fund has invested about 60% of its portfolio in mid-cap stocks, which tend to exhibit greater price volatility than large-cap stocks.

Dividend

The fund has dished out a $0.144 per share dividend every month since March 2005. That equates to an annual payout of $1.73 per share, which gives the stock a yield of 8.6% at today's share price. EOS also carries a management expense ratio of 1.07%, which trims a little off your return.

The fund's 2005 dividend income consisted entirely of capital gains from the fund's premium income and investment sales. Since these were treated as short-term gains of less than a year, the distribution was taxable at your ordinary income tax rate. Assuming a similar composition for this year's dividend, the fund is likely best held in a tax-advantaged account. As yet, the fund does not offer a dividend reinvestment plan.

Performance

EOS uses two management teams to keep the stock picking function separate from the options writing role. Eaton Vance's managers focus on individual stock selection, with the goal of building a portfolio of financially strong stocks with capital gains potential. The idea is not to skew the selection toward stocks that could deliver the greatest option premiums. Meanwhile, independent manager Rampart Investment Management writes the options using computer models to preserve the stock's upside potential.

The fund's strategy of not writing calls on the entire portfolio allows it to benefit from share price gains in a rising market. Over the past year, ending November 30th, the fund delivered total returns of +21%, well ahead of the S&P's gains.

Valuation/Outlook

While no strategy is fail-safe, the fund's performance to date has shown that writing calls is one way to extract greater returns, particularly in a rising market.

In a down market, the strategy provides increased premium income because the stocks are less likely to be called away. However, the premium income may not offset losses in the fund's portfolio.

Like most covered call funds, EOS has but a short track record, and it's too soon to tell how this strategy would work in various markets. That said, its performance has so far been impressive.

The fund is trading at a small premium to the value of its underlying portfolio, and despite rallying sharply over the past year, the shares are still attractively priced.

Action To Take

With its covered call strategy, EOS is particularly suitable for medium-risk investors who believe the stock market will remain in a strong uptrend over the coming year.

EOS 1-yr chart

EOS

Disclosure: Author has no position in EOS.