Is Morningstar Missing Out On The Best Performing Option-Income CEFs?

by: Douglas Albo

I know a lot of fund investors follow Morningstar's ratings of Closed-End funds (CEFs) and I generally agree with their conclusions on most of the equity CEFs they cover but sometimes I just wonder if they've fallen behind the curve when it comes to their analyses on the option-income CEFs. When I look at the NAV performances of many of the option-income funds I follow, I come to a very different conclusion than what Morningstar's CEF analyst does in her analysis. What's interesting is that the analyst also seems to be at odds with what Morningstar's star rankings show, of which I am much more in agreement with. More on that below.

Where I mostly disagree with Morningstar has to do with the Eaton Vance (NYSE:EV) option-income funds. Morningstar's CEF analyst has been especially hard on the Eaton Vance funds though I believe this is unwarranted. In fact, it seemed the only option-income fund they did like up until last year was the Eaton Vance Risk Managed Diversified Equity Income fund (NYSE:ETJ), which was exactly the Eaton Vance fund I haven't liked for years. Morningstar finally went negative on ETJ in late 2011 after its disastrous NAV performance in all market environments finally convinced them that the fund's option strategy was working against them. Something that I had pointed out a long time ago.

On the other hand, there are some Eaton Vance option-income funds that have had some of the best NAV total return performances of all funds I follow and yet Morningstar's CEF analyst barely acknowledges this. Let me first explain how Morningstar goes about analyzing funds. First there is the Analyst Report which gives the current review and analysis of the fund and tends to be more subjective I have found. Then there is the star rating analysis, which rates funds 1-5 (5 being the highest) and takes into account longer term 3-5 year risk adjusted returns against a fund's benchmarks. This tends to be more objective.

Here is where Morningstar's CEF analyst seems to be differing from the firm's star rankings since many of the Eaton Vance option-income funds actually have excellent star ratings but yet the analyst comments don't seem to support this. On the other hand, Morningstar's CEF analyst seems to be more positive on funds that in my research are falling behind in performance and incidentally, don't have as high a star ranking, so something is amiss. Let me show you what I am talking about and then I'll select a couple funds to give as examples.

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The table to the right is from a recent Morningstar article released on June 8, 2012 titled "The Search For Income: Covered-Call funds" and includes Morningstar's star ratings on the option-income funds which are mentioned in the story. This is from a premium service from Morningstar and you would need a subscription to see it directly.

The table, however, doesn't include any subscription level information since anyone can see Morningstar's star rankings. If you click on the table to the right you will see that many of the Eaton Vance option-income funds, which are the ones which start with the letter "E", are 4-star ranked. Again, this is because the star rankings are based on longer term risk adjusted NAV performances compared to a fund's benchmark(s).

However, it's when you read the analyst's reports over the past year or so that the Morningstar CEF analyst is a lot more critical of the Eaton Vance funds.

For example, here's what the analyst has to say about the Eaton Vance Tax-Managed Buy/Write Opportunities fund (NYSE:ETV) which is actually the most positive report I can find on the Eaton Vance option-income funds.

We have mixed feelings about this Bronze-rated fund. Because of its more-passive investment style, the fund has low fees, and longer-term performance measures show strong outperformance of peers because of its 40% concentration in Nasdaq 100 stocks, which have performed well over the past three years. But since 2007, the fund has only outperformed a custom benchmark in two calendar years.

Huh? ETV's Net Asset Value (NYSE:NAV) performance has not only crushed its peers in the US stock based option-income category, ETV has done incredibly well against its benchmarks, including the NASDAQ-100, which has been a very difficult index to outperform because of Apple's (NASDAQ:AAPL) large concentration and because of ETV's defensive option writing strategy. All you have to do is go to ETV's Annual Report dated 12/31/2011 (page 3) to see this, and then go to the Fund Literature tab and click on the Annual Report dated 12/31/2011. As you can see, ETV's NAV has performed extremely well both on a short term and longer term basis against the S&P 500, the NASDAQ 100 and the buy/write indices.

This is verified in my calculations in which ETV's inception NAV of $19.06 back in 2005 would be worth $25.67 today with all distributions added back for a 34.7% total NAV return through June 11, 2012. Compare that to ETV's primary benchmark, the S&P 500 which has had a total return of 24.3% over the same time period, including all dividends. So how does Morningstar come to this negative assessment about ETV when it can be shown and verified that the ETV's NAV has outperformed its benchmark indices both on a short term and longer term basis?

Frankly, most of the Eaton Vance option-income funds (US and global) have performed far better than the BlackRock (NYSE:BLK) or ING (NYSE:ING) option-income funds over the past year and yet I don't see the same level of critical analysis being applied to the BlackRock and ING option-income funds as I do to the Eaton Vance option-income funds. According to Morningstar, the Eaton Vance funds include a lot of "destructive" return of capital in their distributions. This is highly unfair since many of the Eaton Vance option-income funds are managed to maximize ROC and yet they have still outperformed their benchmarks since inceptions. This is not to say that funds don't go through periods in which they include "destructive" ROC, and all option-income funds resort to this at one time or another, but you can't have that kind of NAV outperformance with continuous "destructive" ROC in your distributions.

But don't take my word for it. Here are the shorter term 1-year NAV and market price total return performances for all of the high yielding option-income funds from three of the largest and most recognized fund families that sponsor them; Eaton Vance, BlackRock and ING. I have also included broad based US and overseas indices for comparison, which will give you an idea how much better the US markets have performed than their overseas counterparts. Performance figures are as of June 11, 2012.

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Now all of the ING funds are global and many of the BlackRock funds are global as well whereas only three of the Eaton Vance option-income funds are global, but even the worst performing global Eaton Vance fund, the Tax-Managed Global Diversified Equity Income fund (NYSE:EXG), would have been one of the better performing BlackRock or ING funds over the past year.

And what does Morningstar's CEF analyst have to say about EXG, a fund which is 4-star ranked by Morningstar by the way?

This is one of eight covered-call funds offered by Eaton Vance, and the overall management of these funds has not produced great results. The fund's performance has been mediocre since inception (a total return of 0.60%), and it has relied heavily on destructive return of capital to meet its category-high distribution rate. The fund has earned a Neutral rating.

So how does a 4-star ranked CEF get such a negative review by the analyst? According to my research, EXG has actually outperformed many of the global option-income CEFs in its class and yet I don't see the negative reviews for many of these other funds. For full disclosure, I do not own EXG though I do own many of the other Eaton Vance option-income funds.

The bottom line is if the Eaton Vance funds are using "destructive" ROC to pay for their distributions with some of the lowest NAV yields of all of these funds and some of the best year-over-year performances, then Morningstar needs to update their analysis on the BlackRock and ING funds since they are obviously using a lot more of their NAV to pay for their distributions even if they don't categorize it all as ROC.

For example, here is what the Morningstar CEF analyst says about the ING Global Equity Dividend & Premium Opportunity fund (NYSE:IGD) from earlier this year;

"During 2011, the fund went through a few changes: The lead manager left the management team for personal reasons, and the fund overhauled its options strategy. We believe the new lead manager is more than capable of running this strategy successfully, and we think the changes to the options strategy will benefit shareholders in the long run. Overall, we like this Bronze-rated fund."

Now I like IGD too and I own it, but frankly, the fund has NOT had good NAV performance so far this year or in 2011. In fact, EXG, which would be considered similar to IGD as a global equity CEF with similar option coverage, has significantly outperformed IGD's NAV since the market highs back in late 2007 so I have no idea where the Morningstar's CEF analyst is getting her information. There are other funds I could point out that have favorable reviews without the performance to back it up but you get the gist.

I frankly do not know why Morningstar's CEF analyst is so negative on the Eaton Vance option-income funds, particularly when Morningstar's star ratings seem to indicate otherwise as well. It could be because of Eaton Vance's continued high use of Return of Capital (ROC) in their fund's distributions but as I pointed out earlier, this is the way they are managed and it has NOT been to the detriment of NAV total return performance.

I would encourage investors to own several of the Eaton Vance option-income funds because 1) they trade at the widest discounts of any fund family, 2) they have some of the lowest NAV yields, which makes is easier for the fund to meet its distributions 3) investors receive the highest windfall market price yields because of the discounts and 4). NAV total return performances have been superior, bottom line.

My favorites are the Tax-Managed Buy/Write Opportunities fund, the Tax-Managed Buy/Write Income fund (NYSE:ETB), the Tax-Managed Global Buy/Write Opportunities fund (NYSE:ETW) and for two funds coming on strong, the Enhanced Equity Income fund (NYSE:EOI) and the Enhanced Equity Income fund II (NYSE:EOS).

ETV and ETB have THE BEST NAV total return performances of ALL option-income funds since inceptions. If there are better performing option-income CEFs, I'd like to know what they are.

For a turn around story, EOS & EOI have two of the best year-to-date NAV performances of all option-income funds. Historically, their NAV's have lagged their benchmarks, but I like where they are headed now. The other nice feature of EOS and EOI is that they are monthly pay.

Disclosure: I am long ETV, ETW, ETB, EOS, EOI, IGD.