Rating The Global Equity Option-Income CEFs

by: Douglas Albo

With the markets entering a seasonally more difficult period and the overseas markets looking more and more unsettled, I thought this might be a good time to review the high yielding global option-income (also called covered-call or buy/write) closed-end funds (CEFs) to see which ones might offer good value going into this more difficult period.

If you are a reader of my articles, then you know that I favor the leveraged CEFs this year over the option-income CEFs to take advantage of a better 2012 for equity markets, however, I have to be cognizant of the fact that the summer and fall seasons are not always kind to the equity markets and that more defensive CEFs can make up lost ground during this period.

Option-income funds are more advantageous during flat to even down market periods because they sell (write) index and individual stock options on their global stock portfolios which can bring an immense amount of income to the funds dependent on how high a coverage the fund utilizes. The higher the coverage, the more income the fund can generate, all else being equal. With the overseas markets once again in turmoil, global ETFs and mutual funds can have significant downside risk and investors may want to consider CEFs that can at least offer some defensive measures by selling options on their portfolios and offering high yields while you wait. In other words, weak overseas markets will not stop global CEF portfolios from losing Net Asset Value (NAV) but their income strategy of writing index or individual options on their portfolios will be more optimized in such a market and the funds can at least "earn" their high distributions and yields. Many of these funds offer 10% to 12% annual market yields which is a lot more attractive than sitting in near 0% cash.

So which funds offer the best valuations? Here are the 13 global equity funds that use an option-income strategy, have at least 95% of their portfolios in diversified stocks (i.e. not bond or sector specific) and have at least 50% or so of their portfolios in international stocks. These funds come from such large and diversified financial institutions as BlackRock (NYSE:BLK), ING, Eaton Vance (NYSE:EV), Allianz-Pimco, John Hancock and Wells Fargo (NYSE:WFC).

Table 1 shows the funds ranked by their Premium/Discount level which can be a good starting point for evaluating which funds might be over or under valued. Other data shown includes YTD NAV and market price performances as well as other relevant information, some of which have red flags for what I consider may be overly high premium valuations, NAV yields or expense ratios. NAV and market price performances include all distributions added back but not reinvested. All information is as of May 14, 2012.

Table 1: Funds sorted by YTD NAV Performance

Together, these funds represent over $8 billion in assets. Many have seen distribution cuts over the past year as shown in the far right column in the table though I don't necessarily consider this a huge negative since many of these funds offer some of the highest yields of all CEFs and many have already seen their NAVs suffer over a difficult overseas markets for the past year or so. Investors need to realize that rebalancing a fund's distribution with its income is part of the risk you take with these funds that have exceptionally high yields. That does NOT mean though that a fund's total return performance (NAV plus distributions) is suffering since an offset in distributions can be made up in NAV sustainability. In fact, many of these funds have better total return NAV performances than their benchmark averages since their inceptions, even with distribution cuts.

One of the best ways to rate CEFs is to see how their NAVs have performed over different market environments and not just 1-year, 3-year or 5-year periods. Table 2 below sorts the funds by their NAV performance from roughly the market high at the end of the 3rd quarter of 2007 while Table 3 sorts the funds by NAV performance from roughly the market low at end of the 1st quarter in 2009. The theory is that if a fund's NAV can perform well under both scenarios then it should trade at a higher valuation. Again, these are total return performances through May 14, 2012 with all distributions added back.

Table 2: NAV Performance from 3rd Quarter, 2007 Market High

Table 3: NAV Performance from 1st Quarter, 2009 Market Low

Having these tables to refer back to, here are my best and worst ratings among the global option-income CEFs.

Best Buys For A Flat to Down Market:

Eaton Vance Tax-Managed Global Buy/Write Opportunities fund (NYSE:ETW): $10.57 price/$12.31 NAV - I've written several times on ETW and nothing seems to help this fund's market price performance. This is really a surprise since ETW has one of the best NAV performances of all global option-income funds since its inception. ETW was one of only two global option-income funds that I follow (HTY being the other) that had positive total return NAV performance in a very difficult 2011 and yet it closed the year at one of the widest discounts at -15.9%. Just to give investors perspective as to how undervalued this fund is, ETW's NAV has actually outperformed the S&P 500 and other benchmark indices since its inception through 2011. That may be hard to believe but go to Eaton Vance's Annual Report dated 12/31/2011 and this just confirms what I have been saying all along.

Over 1-year, 5-years and since inception on September 30, 2005, ETW's NAV has outperformed the S&P 500 through 2011, and ETW is a global fund, not just a US stock only fund. These may not be huge outperformance figures but considering the reputation ETW and Eaton Vance option-income funds get, I think the NAV outperformance would shock most investors who follow these funds. Then consider that ETW trades at the widest discount of all the global option-income funds at -14.1% and is also one of the most defensive CEFs you can find selling 95% index options (S&P 500, NASDAQ 100 and select international indices) on its large cap stock portfolio and ETW is the most undervalued global option-income funds, particularly in a more difficult global market environment.

I know most investors only follow the fund's market price performance and from that perspective, ETW has been frustrating. However, the fund managers can only control the NAV of the fund and not its market price. If investors want to sell an outperforming fund at a -14.1% discount, then that is their prerogative, but in my experience with these funds, THAT is where the opportunity lies. ETW also has one of the lowest and most easily covered NAV yields at 9.5% but because of the discount, offers one of the highest windfall yields to investors at 11.1%. At some point, someone other than myself is going to realize the value this fund offers.

Besides ETW, the next best defensive option income fund is the ING Global Advantage & Premium Opportunity fund (NYSE:IGA): $11.21 price/$11.98 NAV - IGA sells a relatively high 67% option coverage on its mostly large cap portfolio and like ETW, is evenly balanced between US based stocks and international stocks so this may also appeal to investors. At a -7.3% discount and a generous 11.2% market yield, IGA has the widest discount of all the global ING funds, many of which continue to trade at close to par and premium market prices even with very average NAV performances.

Best Buys For An Up Market

Should the global markets reverse course and move back to the upside, leveraged global CEFs offer the best appreciation potential and as it so happens, there is a global option-income fund that also uses leverage. The Cohen & Steers Global Income Builder fund (NYSE:INB): $10.02 price/$10.96 NAV - INB uses a combination of 57% option coverage on its global portfolio along with 23% leverage to offer more kick to the upside in a stronger market environment. This is shown in Table 2 in which from the market lows, INB's NAV shows a leading 78.7% return and a very strong 118.7% market price return through May 14, 2012. INB is also attractive at a -8.6% discount and an 11.2% market price yield.

ING Asia Pacific High Dividend Equity Income fund (NYSE:IAE): $14.82 price/$14.95 NAV - I wasn't initially going to add IAE but after the shellacking it received on Monday, down 4.1%, I decided to add it. As its name implies, IAE's stock portfolio is concentrated in Asia and Australia (largest country allocation at 25%) and with a very low 25% option coverage, IAE can move up both in NAV and market price very quickly with a rebound in Asian and Australian markets. IAE is also very volatile however, moving between wide premium and discount market pricings depending how the Asian wind is blowing.

BlackRock International Growth & Income Trust fund (NYSE:BGY): $7.18 price/$8.02 NAV - BGY is also an aggressive pick and a turnaround story. With very little US exposure, an inception date close to the highs of the market in 2007 and a distribution that was kept too high for too long, BGY has not had a good track record of NAV total return performance. BGY was overdue for a large distribution cut and that finally occurred in March when BlackRock declared a 35% cut in BGY's quarterly payout. The subsequent fall in market price has resulted in a current -10.3% discount that I felt presented a reasonable value for a fund that could now have better NAV appreciation performance in a global market recovery.

Worst Global Option-Income Funds

Allianz International & Premium Strategy fund (NYSE:NAI): $10.23 price/$10.19 NAV. As a pure international fund with no US exposure, NAI is more dependent on overseas markets which has contributed to it's underperforming NAV over the years. However, a perpetually high NAV yield that is currently at 15.7% has also contributed to its NAV erosion from what was a $23.88 inception NAV back in 2005, whereas most of these funds started with much lower $19 NAVs. NAI is one of those funds that has "destructive" Return of Capital in its distributions and at a slight market price premium, NAI is overvalued compared to the other funds. I believe NAI will continue to see NAV erosion until action is taken to better balance the fund's income with its distribution.

Wells Fargo Advantage Global Dividend Opportunity fund (NYSE:EOD): $7.99 price/$8.32 NAV - EOD is another fund that has too high an NAV yield at 13.5% and could be due for a distribution cut. Looking at Tables 2 & 3, you can see that both NAI and EOD have some of the worst NAV performances from both the market high and from the market low. This is what can happen when fund sponsors leave a distribution too high for too long and the NAV erodes to a point where the high market yield doesn't make up for the poor NAV performance.

Final Word on Return of Capital (NYSE:ROC) and Distribution Cuts

I know a lot of readers will point out the high Return of Capital in these fund's distributions so let me just say that virtually all option-income funds have high ROC because of how they manage their option overlays. In fact, many fund managers will try to minimize capital gains and maximize losses so that they can maximize ROC in the distributions, hence why many have "Tax-Managed" in their names. How do they do this? In an up market environment, instead of allowing option contracts to be settled and have cash or securities called away, most funds will buy back the option contracts before expiration at a loss and re-establish at higher strike prices further out. This way the fund holds onto their capital gains in their equity positions and can realize losses in their options. In a down market, the fund's will realize gains in their options positions but can offset those gains to a degree by either selling losing equity positions or using capital loss carryover. In either environment, option-income funds can use net capital losses so that much of a distribution can be designated as ROC. Again, the option-income strategy works best in volatile, trendless markets like we had in 2011. Option-income fund's NAVs will appreciate in up markets, particularly the low option coverage funds, but not as much as leveraged funds typically.

And finally, there is a give and take when it comes to a fund's distribution level and the sustainability of a fund's NAV. Although nobody likes to see distribution cuts, you want a fund manager to be pro-active in rebalancing a fund's distribution with its income since in the long run, this will result in better total return NAV performance. Investors can easily get lulled into funds that have too high a market or NAV yield without looking at the long term consequences of this. I hope these tables point out to investors this fact.

Disclosure: I am long ETW, BGY.