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Eaton Vance Tax-Managed Diversified Equity Income Fund (NYSE:ETY) is a covered call equity closed-end fund with about $1.9 billion in assets under management. The primary objective of the fund is to provide current income and gains, with a secondary objective of capital appreciation. The fund evaluates projected returns on an after-tax basis, and seeks to minimize and defer shareholder federal income taxes.

Under normal market conditions, ETY invests at least 80% of total assets in a combination of:

  • Dividend paying stocks (that pay qualified dividends).
  • Common stocks hedged by selling short-term out of the money stock index call options.

ETY offers three potential sources of tax-advantaged income:

  • Qualified dividends (max 15% tax rate)
  • Capital gains from stock price appreciation (max 15% tax rate)
  • Premiums from index options that qualify as “Section 1256 contracts” (60% long term, 40% short term)

Within the equity covered call CEF sector, I prefer funds that write stock index options over those that write options on individual stocks. Aside from the tax advantage, the options on stock indexes generally trade with a lower bid-asked spread and are more liquid. This means reduced “slippage” costs resulting in less drag on performance.

In the first few years of its existence from 2005 through 2009, ETY used a high managed distribution plan where they paid out $0.4625 per quarter. But the NAV was falling over time because the total return did not keep up with the distributions. ETY relies on return of capital distributions as needed, which is not so bad for a tax managed fund, since taxes are deferred on ROC distributions.

The quarterly distribution was reduced to $0.4057 in January, 2010 and was lowered again to $0.2895 in December, 2010. The distribution cuts (and a more bullish market) have prevented further drops in NAV. For the last two years, ETY has increased its NAV from $11.64 on April 30, 2009 to the current NAV of $12.42.

The portfolio is largely domestic with some global exposure. This was the top five sector breakdown as of Dec. 31, 2010:

Financials

14.9%

Energy

14.8%

Health Care

10.8%

Consumer Discretionary

10.6%

Consumer Staples

10.4%

The Country allocations as of Dec. 31, 2010 were:

Country

Allocation (%)

United States

73.95

Europe

14.21

United Kingdom

7.74

North America ex/US

2.33

Asia Pacific

0.94

Latin America

0.83

Calendar Year NAV Performance (before taxes)

2007

+6.55%

2008

-24.83%

2009

+26.36%

2010

+4.64%

YTD

+4.59%

The top ten holdings on Feb. 28, 2011 were:

Stock

Allocation (%)

Apple

3.46

Danaher

1.91

Google

1.85

Vodaphone

1.82

Hess Corp

1.75

Accenture

1.35

Conoco Phillips

1.33

Cisco

1.31

Proctor & Gamble

1.29

Citigroup

1.23

Option Writing Strategy

As of year-end, the fund hedged about 50% of the portfolio with stock index calls with an average duration of 21 days. They typically sell the first strike price out of the money. I believe ETY could realize better performance if they were more selective in their hedging strategy and adjusted the percentage of calls written based on the VIX index. When the VIX index is too low, option writing can be a losing strategy. Unfortunately, nearly all of the covered calls funds continue writing options regardless of the VIX index value because they need to keep up their distribution payouts.

Fund Management

Walter A Row, CFA

  • Director of Structured Equity Products.
  • Joined Eaton Vance in 1996.
  • B.S. Yale University; M.B.A. Harvard Business School

Michael A. Allison, CFA

  • Vice President, Eaton Vance Management
  • Joined Eaton Vance in 2000
  • B.S. B.A. University of Denver

Ticker: ETY Eaton Vance Tax Managed Dividend Equity Fund pays quarterly

  • Total Assets= $1.9 Billion Market Value= $1.7 Billion
  • Annual Distribution (Market) Rate= 10.39% Income Only Yield= 1.11%
  • Fund Expense ratio= 1.07%
  • Discount to NAV= -10.31%
  • Avg 6 month Discount to NAV= -7.62%
  • Portfolio Turnover rate= 25%
  • Average Daily Trading Volume= 521,000 Average Daily $ Volume= $6 million
  • No leverage used

The discount to NAV as of December 17 is -10.31% which is not far from the maximum 52-week discount of -10.54%. The 52 week discount Z-score is -1.49, which means that the discount to NAV is about 1.5 standard deviations below the average discount over the last year.

This looks like a good time to buy ETY for an income-oriented, risk-averse investor who wants to participate in equities but with some hedging. It is liquid and easy to purchase. But I would consider selling ETY if the discount narrowed to 4% or less. ETY can be purchased for a tax deferred IRA account, and is also a good candidate for a taxable account because of the three sources of tax-advantaged income that it pays out.

Source: ETY: A Good Equity Covered Call Fund for a Taxable Account