It is time for Eaton Vance to change the investment strategy for its option-income Closed-End fund ETJ. As its name implies, ETJ is one of only two "risk managed" high-yielding equity-based CEFs that buy index put options on 100% notional value on their portfolios (IRR being the other). Some option-income CEFs also buy put options but on less coverage; however, the vast majority of option-income CEFs only sell call options on their stock portfolios to generate income for their large dividends.
The problem with CEFs that also buy put options for enhanced downside protection is that income that could be used for dividends is instead used to buy the put options. This may be fine in a down market environment where the value of the put options goes up, but in an up market environment like we have had over the past two years, the strategy can take a large toll on a fund's NAV as the value of the put options deteriorates and just adds to the NAV erosion along with the fund's dividend distributions.
This is essentially what has happened to ETJ and even IRR, though because IRR has a narrower sector focus of integrated oil and gas, oil service, gold, metal, commodity and other natural resource stocks which have done very well, its NAV has also done relatively better over the past two years even though its NAV is also lower now than at the market lows of March of 2009, not including dividend distributions.
The real problem with ETJ is not its portfolio of stocks, which represent a broad mix of S&P 500 names, but a strategy that has not allowed its NAV to grow in either a down or up market cycle. According to Eaton Vance's Annual Report, as of December 31, 2010, ETJ had almost $200 million in unrealized capital gains in its equity portfolio, but suffered almost $114 million in realized losses in its option purchases. This doesn't even include the losses the fund incurred on the options written or sold. This for a fund that represents about $1 billion in assets.
Even during the market fallout from late 2007 to early 2009, when ETJ's NAV held up much better than the overall market, its NAV still eroded even when the $2.70 worth of dividends the fund paid from the fourth quarter of 2007 to the first quarter of 2009 is added back. ETJ went public in late July 2007 and started trading in August of that year, so its strategy should have been optimized for the first 20 months of a mostly down market period.
The following graph shows ETJ's NAV performance since inception. The inception price of $19.06 is now down to $14.31 as of April 5, not including the $6.17 in total dividends the fund has paid since inception. The straight black line represents the market low in early March 2009 dividing out the bear and bull market cycles.
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The fact that ETJ's portfolio managers have not been able to take advantage of market cycles either up or down is problematic, and won't going give investors confidence that they can turn things around with the current strategy. Since the market lows of March 2009, both ETJ's market price and NAV have been nothing short of a disaster compared to the overall market performance, and I believe it has dragged down all of the Eaton Vance option-income fund prices because of its poor performance.
There is a wide valuation discrepency between fund families that offer high yielding option-income funds; Eaton Vance has the lowest valuations currently. Most of Eaton Vance's option-income funds are in the 9% to 10% market price discount range, even though most of the fund's NAV performances have been consistent with other option-income funds.
Compare that to BlackRock's (BLK) and ING's option-income funds, in which many are close to par or even at premiums with similar NAV performances, and investors obviously continue to penalize Eaton Vance. Even Nuveen's (NUV) option-income funds are valued higher than Eaton Vance's, and Nuveen is more known for its fixed-income and bond funds.
Eaton Vance needs to admit that it's unable to effectively manage this fund with the strategy it has in place. Last August, Eaton Vance took steps to try and offset the huge put option purchase expense by selling deep in-the-money put options starting in November 2010 (see below). This "put option spread" unfortunately has only added to the complexity of the fund's strategy, since the fund's portfolio managers were having a difficult enough time even before implementing a "put spread."
Dropping the buy put component of ETJ's strategy would not be without precedence. During the fall of 2007, I recommended to Nuveen that it drop the 100% notional value put option purchases on its option-income funds JSN, JLA and JPZ, since they were receiving no valuation credit for their downside protection. By November of 2007, Nuveen decided to do just that and eliminated the purchase of protective put options. Even though the timing was not good -- as the markets were hitting their highs around the same time -- ultimately the Nuveen option-income funds JSN, JLA and JPZ were able to reduce their discounts substantially, once the markets recovered.
The good news for ETJ is that it is not too late to change strategy. ETJ's NAV held up relatively well during the market fallout period, so its poor performance over the last two years has not dragged down the NAV to levels that I would consider dangerously low for another dividend cut. Still, Eaton Vance needs to realize that its strategy is not working and, even if the markets start a more difficult cycle, it would be wise to eliminate the added expenses and complexity associated with the "put option spreads" and just stick with what the vast majority of other option-income CEFs do: Only sell call options to pay for dividends.