Eaton Vance's Tax-Managed Global Diversified Equity Income fund (NYSE:EXG) and Tax-Managed Diversified Equity Income Fund (NYSE:ETY) both go ex-dividend on Wednesday, February 16th. I believe this presents an opportunity for investors to get in ahead of the ex-dividend date on two 10%+ yield Closed-End Funds (CEFs) that haven't been this attractive to investors since the spring of 2009 when most Closed-End Funds were recovering off their market lows. Note: An investor would need to purchase the fund(s) by the market close on Tuesday, February 15th to be entitled to the dividend.
EXG and ETY have had a rough go of it recently, some of which is deserved, and some of which is based on misinterpretation of the source of these funds' high distributions and why these funds' have lagged in performance. Still, at a 10.44% current annual yield for EXG and a 10.10% current annual yield for ETY even after recent dividend cuts, a lot of the bad news is already built into these funds and I believe EXG and ETY offer compelling valuations with no more changes in distribution rates anticipated for at least the remainder of the year, and probably well beyond that.
First the fund basics:
Tax-Managed Global Diversified Equity Income fund (EXG)
Inception Date: February 23, 2007
Inception Price: $20.00
Inception NAV: $19.06
Current Price: $10.89
Current NAV: $11.78
Current Yield: 10.44% (Quarterly pay cycle)
Market Cap: $3.6 billion (2nd largest of all CEFs)
(1) As a percentage of the Fund’s total investments as of 10/31/10.
(2) Top 10 Holdings represented 23.3% of the Fund’s total investments as of 10/31/10. Top 10 Holdings do not reflect the Fund’s written option positions at 10/31/10.
(3) As a percentage of the Fund’s total investments as of 10/31/10. Sector Weightings do not reflect the Fund’s written option positions at 10/31/10.
Tax-Managed Diversified Equity Income Fund (ETY)
Inception Date: November 27, 2006
Inception Price: $20.00
Inception NAV: $19.06
Current Price: $11.47
Current NAV: $12.53
Current Yield: 10.10% (Quarterly pay cycle)
Market Cap: $1.9 billion (12th largest of all CEFs)
(1) As a percentage of the fund’s total investments as of 10/31/10.
(2) Top 10 holdings represented 19.4% of the fund’s total investments as of 10/31/10. Top 10 holdings do not reflect the fund’s written option positions at 10/31/10.
(3) As a percentage of the fund’s total investments as of 10/31/10. Sector weightings do not reflect the fund’s written option positions at 10/31/10.
EXG and ETY are both global equity option-income funds that use no leverage and have no fixed-income securities in their portfolios. Their portfolios include mid to large cap global stocks in which roughly half the portfolio value is written against by selling index options. If you have read my past articles discussing the methods by which equity-based high-yielding CEFs generate their income (CEFs: Income Strategies for all Market Seasons), then you would know that selling covered-call options can be an effective and conservative strategy to generate income in flat to down market environments.
I say conservative because the worst market environment that these funds encounter is a ramp up market in which not only the fund's benchmark indexes outperform the holdings of the fund, but the option strategy also results in a drag on NAV performance due to the funds being forced to re-purchase open option contracts and re-establish them at higher strike prices, usually at a transactional loss. Though EXG's and ETY's NAVs can grow in this ramp up market environment, they won't appreciate as fast as their correlated indexes.
This is exactly what happened in 2010 for EXG and ETY. Their portfolios underperformed their benchmark averages (a blend of the S&P 500 & FTSE Eurotop 100 Index) and the funds paid large dividends along the way. As a result, EXG’s NAV only appreciated 3.87% and ETY’s NAV 4.43% for 2010. Both percentages include reinvestment of dividends. Due to this underperformance and in an effort to capture more market upside in 2011, Eaton Vance cut the dividends on all of their option-income funds on December 14, 2010. These cuts were anticipated for EXG and ETY and were generally looked upon by analysts as a positive step.
In a research report from Morgan Stanley Smith Barney two weeks after the announced dividend cuts, the analyst reiterated his overweight on both funds, citing the exceptionally wide discount rate compared to most other global option-income CEFs. According to the analyst's report, both funds discounted market prices dropped to 2X the 5-year average of their peers. As of 2/11/11, EXG's market price discount to NAV stood at 7.56% and ETY's at 8.46%, a slight improvement from the post dividend reduction announcement, but still the widest since the spring of 2009.
EXG Premium/Discount graph since inception
Another potential reason for EXG's and ETY's market price weakness, which I'm sure has just intensified since the dividend cuts, is the controversy surrounding option-income funds' Return of Capital [ROC] in their distributions. ROC has been a source of contention with investors and analysts alike and was one of the reasons why I wrote an article (CEFs and Return of Capital: Is It as Bad as it Sounds?) to try to address this controversy.
In essence, return of capital results when any part of a dividend distribution is not investment income (portfolio dividends and interest) or realized capital gains. Because of their options management and defensive strategy, option-income funds are in a position to generate alot of ROC by allowing mostly unrealized capital gains to accumulate in their stock holdings during up market periods and taking realized losses in their stock holdings during down market periods. The end result is that up to 95% of each distribution can be return of capital.
This does not mean that the funds are not generating enough income to pay for their dividends, which in essence would be the real definition of ROC, it's just that option-income funds strategy is most efficient in trendless flat to down markets and will underperform in a ramp up market like we're currently in. In fact, portfolio managers at Eaton Vance actually attempt to maximize the return of capital component in their distributions because of the tax nature of ROC. ROC is non-taxable in the period it is received, though an investor would need to lower the cost basis of their investment in the security by the ROC amount.
To show how effective an options-income fund can be when the fund includes a well-selected portfolio of securities, one has only to look at ING's Infrastructure, Materials and Industrials fund (NYSE:IDE). IDE is also an option-income global stock CEF like EXG and ETY, though IDE only focuses on a few industrial sectors in its portfolio while EXG and ETY are more broader sector represented. Like EXG and ETY, IDE sells options on a low percentage of its total portfolio valuation, about 35%. EXG and ETY also have relatively low option coverage on their portfolios, about 57% and 50% respectively.
These are among the lowest of all the Eaton Vance option-income funds. What this means is that the overall NAV performance of these funds will be more dependent on stock selection since the funds can't depend as much on option premium to pay the distributions with the lower option coverage. This is why EXG and ETY's subpar portfolio performance last year made for an even worse NAV performance. On the other hand, IDE's NAV had exceptional performance due to its well performing stock holdings in superior performing sectors.
Including reinvested distributions, IDE's NAV was up a whopping 30.7% over the past year through 2/11/11. And how much of IDE's distributions were classified as return of capital? About 86%, about the same as EXG and ETY. Obviously, high ROC percentages are not necessarily indicative of an underperforming fund. What's interesting to note about IDE is that since going public on 1/27/2010, it has one of the largest discounts of all the CEFs I follow, over 10%, because investors kept cashing in at the $20 inception price which has acted as a resistance level even while the NAV continued to climb past $22. So much for being rewarded for superior NAV performance for a fund that will probably be in a position to raise its dividend before long.
Though the purpose of this article is to alert investors of an upcoming dividend distribution of two funds that are already heavily discounted, this article does not address the real issue concerning EXG and ETY. What will bring investor confidence back to EXG and ETY will not be a lower return of capital percentage, or any more distribution adjustments, or a change in the options strategy. No, what will bring investor confidence back to EXG and ETY will be when the portfolio managers at Eaton Vance are able to select a portfolio of global stocks that will outperform, or at least keep up, with their benchmark indices.
Until then, the Eaton Vance option-income funds will continue to trade at lower discount valuations compared to their peers. That being said, I believe the current discount levels for EXG and ETY assume a worst case scenario by investors that includes a heavy dose of misunderstanding behind the reasons for the dividend cut as well as a general lack of enthusiasm for option-income funds currently. In other words, I believe it can only get better from here.
Disclosure: I am long ETY.