Option Income CEFs: The Fallacy of Failure

Includes: EOS, ETB, EXG, NFJ, PGP, SPY
by: Douglas Albo

I wanted to write an article addressing the perception that a lot of investors seem to have concerning the option-income closed-end funds (CEF's). I keep reading articles questioning the wisdom of covered-call writing or hearing from readers about dividend cuts or high Return of Capital percentages and how they rue the day they bought this or that option-income fund. I've thought about how I can help make investors feel more confident about owning these funds even when they believe that they are nothing but investment traps or even worse ... fund failures. So here goes ...

In mid April of this year, I wrote an article on the Eaton Vance Tax-Managed Buy/Write Income fund (NYSE:ETB) and why investors should consider this under appreciated fund trading at a historically wide 9% discount and a 9.4% dividend yield. Since that article, not much has changed for ETB as it is still at a 9% discount and a 9.5% dividend yield. Obviously, I need a more convincing argument.

I suppose if one just looked at the long term graph of ETB's Net Asset Value (NAV) from inception compared to its benchmark index, the S&P 500 (see below), it might be hard to tell that ETB's NAV performance has actually trounced that of the SPDR S&P 500 ETF (NYSEARCA:SPY). The NAV of a fund is the true apples-to-apples comparison to use while the market price of the fund can go wherever it wants based on investor perception, and I'll get into that a little later. Looking at the graph would probably not give you a warm and fuzzy feeling regarding ETB's prospects. And combined with its high Return of Capital percentage and first ever dividend cut last December and it probably makes perfect sense that investors would penalize ETB's market price down to a 9% discount below its NAV. Note: XETBX is the NAV symbol for ETB.

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However, it's when you look past the surface and dig a little deeper into the fundamentals of this fund that you realize things are not as bad as they appear. The following table will show how ETB's NAV has actually significantly outperformed its benchmark index, the S&P 500, by a wide margin from inception. More importantly, during the most difficult period of the market from the fourth quarter of 2008 through the first quarter of 2009, ETB's NAV held up dramatically better than the S&P 500. When the S&P 500 was down over -23% at the end of March 2009 from ETB's inception date of April 27, 2005, ETB's NAV was actually still positive on a total return basis.

The table below includes actual prices at the end of each quarter for both ETB's NAV and the SPDR S&P 500 Index ETF (SPY), the largest and most heavily traded Exchange Traded fund. Dividend amounts that were distributed for both ETB and SPY during the quarter is also shown and added back to the prices (for comparison purposes, dividends are not assumed to be reinvested). This gives you a cumulative Total Dividend and an Adjusted price which includes the total dividend. From the Adjusted price, we can then calculate the Total Returns from 4/27/2005, ETB's inception date. Bull market periods are shown in green and bear market periods are shown in red.

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So from inception on April 27, 2005, through July 19, 2011, ETB's NAV had a total return of 34.7% compared to the S&P 500's total return of 26.2%. Surprised? I think a lot of investors would be absolutely shocked to learn that ETB's NAV and other option-income funds' NAVs are not only keeping up with their benchmark averages, particularly now with a market environment more conducive to their income strategy, but many have outperformed their correlated indices. So how is it that if you just looked at these fund's market prices, in which many are closer to their two-year lows and trading at heavy discounts, you would think the world is falling apart?

I'm guessing that if an investor simply graphed these funds, they would completely miss the fact that many of these funds are now offering some of the best valuations since the market lows in early 2009. The problem when one only performs a cursory analysis of these funds' NAVs and market prices is that the graphs don't include the fund's large dividend payments every month or every quarter and so many investors get a skewed perception and end up not touching them with a 10-foot pole. This seems to be the case with ETB's market price performance which gives little hint of the solid outperformance its NAV is showing. Below is a one-year graph of ETB's market price compared to SPY.

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I have tried to show investors in article after article why the option-income funds are very attractive in the current up and down market environment we are in and particularly if we go into a more negative market environment. If we go back to a ramp-up market like the two years prior to April, then yes, there are better funds to invest in such as the leveraged funds. But I'm having a tough time believing we'll see another double of the S&P 500 over the next two years.

Investor perception of individual CEFs can drive their market prices down to 20% discounts or up to 60% premiums over their NAVs in some cases, see the PIMCO Global StocksPlus and Income fund (NYSE:PGP). Many of these valuations are based more on investor emotions rather than true fundamentals and many are a disappointment waiting to happen. I have seen CEFs trade at lofty premiums because of an exceptionally high dividend yield only to see them come crashing down when the inevitable dividend cut occurs. And I have seen CEFs languish at significant discounts because the yield was too low even as the NAV was being rebuilt, see the NFJ Dividend, Interest and Premium Strategy fund (NYSE:NFJ).

I have been following and investing in CEFs for about six-years now and I have far outperformed the broader market during that time period, so I think I know what I am talking about with these funds.* I hope this article inspires investors to perform more due diligence on CEFs because quite often, there is more than meets the eye and opportunities can be uncovered.

Note: ETB just went ex-dividend on July 20th and won't go ex-dividend for another three months. Other option-income funds I would recommend that either pay monthly dividends or have next rotation ex-dividend dates include EOS and EXG. Both have had excellent NAV performance YTD and both also trade at 9%-10% discounts.

*Past performance should not be considered indicative of future results.

Disclosure: I am long ETB, EOS, EXG, NFJ.