David vs. Goliath in the CEF Space: Comparing PIMCO's PGP to Eaton Vance's ETB

Includes: ETB, ETJ, ETV, ETW, PGP
by: Douglas Albo

I've been advising investors to over-weight the high yielding option-income or buy/write closed-end funds (CEFs) since March to take advantage of a more volatile, range bound market that would finally benefit their income strategy after two years of a mostly ramp up market that favored the high-yielding leveraged CEFs. By and large, this volatile, range bound market is exactly what we have been seeing over the past few months and this should have been good, actionable advice. Unfortunately, the market prices of many of the option-income funds have not responded and the discounts have just widened to levels not seen since the spring of 2009 when the markets were coming off their bear market lows.

What's even more frustrating is that investors continue to want to jump back into the leveraged funds at the first sign of a market upswing even though it's pretty clear we're not going back to a ramp-up market that favors that strategy anytime soon. So I will continue to stress to investors what strategy is working best right now, at least at the NAV level, even if it means going out on a limb to get my point across. So what better way to get my point across than to take on the most popular CEF out there and compare it with my favorite option-income CEF, a sort of David vs. Goliath story.

The two funds I'm going to compare are on opposite sides of the market, as in long/short and certainly on opposite ends of popularity currently. They have some surprising similarities as well as large differences. Both are high-yielding CEFs that rely heavily on index option contracts to generate income and capital gains that they pass on to investor's in the form of large dividends. One fund accomplishes this by being short S&P 500 options and the other by being long S&P 500 mini futures.

There is perhaps no CEF that has garnered more popularity and devotion by investors than the PIMCO Global StocksPlus and Income fund (NYSE:PGP) as witnessed by its 58% premium valuation to its Net Asset Value (NAV) as of August 2, 2011, the highest of all CEFs. Contrary to popular belief, PGP does not own stocks but rather is mostly a fixed-income and corporate bond fund. However, the StocksPlus name comes in because PGP's strategy has been to use the cash flow from its bond portfolio to purchase large holdings of S&P 500 mini futures contracts, which are leveraged similar to S&P 500 index options. How large? According to PGP's portfolio holdings as of 3/31/2011, these S&P 500 mini futures contracts represent about 30% of the fund's total assets or about $75 million in long S&P 500 contracts out of a total of $257 million.

On the other side of the spectrum is the Eaton Vance Tax-Managed Buy/Write Income fund (NYSE:ETB) which is a much more defensive fund and sells S&P 500 option contracts on 94% notional value of its portfolio of large-cap domestic stocks. There are many option-income or buy/write CEFs available to investors, but I don't know of any that have as high an option coverage as ETB and have had as good of long term performance. Nonetheless, ETB has been thrown out and disregarded by investors and is now at a two-year low and a 10% discount, even though its income strategy is optimized in the current market environment.

One would think that a defensive fund at a large discount would be getting a lot of interest right now compared to a fund that is leveraged long and is at an absurd premium, but such is the fickleness of CEF investors it seems. The reason why I wanted to highlight these two CEFs is not just because of the extreme valuation difference in light of current market conditions but because they both came public only a month apart in 2005, so this makes for a very good side-by-side comparison during bull and bear market periods. The other reason, as mentioned above, is because both funds use S&P 500 futures contracts, one long and one short. And finally, both funds offer similar market price dividend yields around 10%, in fact ETB's is a more stable 10.1% vs. PGP's more precarious 9.9%, and I'll explain that later. Certainly, PGP is a bull market CEF and ETB is a more defensive CEF. So, the question is, would you rather be in a defensive fund which is short index options right now or would you rather be in a fund that is leveraged long index futures? This should be an easy answer but it becomes even easier when you look at how both funds have performed over the long haul and especially during difficult market periods.

PGP came public at a $23.83 NAV ($25 market price minus a sales credit) and ETB came public a month earlier at a $19.06 NAV ($20 market price minus its sales credit). Even starting out with a higher NAV, which fund do you think has a higher current NAV? That would be ETB at $14.22 vs. PGP at $13.92 as of August 2, 2011. And yet, PGP trades at a $22.09 market price vs. ETB at a $12.80 market price. Think about that for a second. A fund with a higher NAV and which should hold up better in a more difficult market environment, trades at a market price over 40% below that of a leveraged fund.

Let me go further and add something most investors don't think about when they buy a fund at such a high premium. PGP's NAV yield, which is a much more accurate barometer of what the fund is actually paying, is a whopping 15.5% vs. ETB's NAV yield of 8.9%. Tell me, which one of these fund's is better balanced to pay dividends to its investors in any market environment let alone a more difficult market environment? ETB has about twice the coverage needed to pay its quarterly dividend now after cutting its distribution in December. Throw in a more difficult market environment which now strongly favors ETB, and PGP is far more likely to have to adjust its dividend at some point. Of course, PIMCO will be loathe to do this because they know the bloom will be off the rose for all of their high premium funds if they do that.

But let me go even further. Let's take a look at how these CEFs have done side-by-side since inception and during bear and bull market periods. Perhaps then investors can see firsthand how these funds perform in different market environments. The following table shows the quarterly NAV values and performances of ETB and PGP over the six years since inception. I used PGP's inception of 5/31/2005 as a start date because it was a month later than ETB's. All dividends and capital gain distributions are added back (not reinvested) since PGP had large capital gain distributions in years 2007 and 2008, taxable I might add. The periods are broken down by bull (green) and bear (red) market periods.

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So even after a six-year period in which we had a mostly up market with one nasty bear market in between, the darling of the CEF world could barely outperform a lowly defensive option-income fund that has been disregarded and tossed aside like an old rag. And when the going got tough in late 2008 and early 2009, only one fund's NAV stayed positive on a total return basis while the other dropped to a 20% loss. Feel free to check my statistics but the numbers don't lie.

Investors need to ask themselves is PGP really worth the higher risk with its leveraged long S&P 500 futures and a 57% premium to its NAV when there is an ignored fund that is more defensive and historically less risky trading at a -10% discount and over time has done just as well? Here is the graph of ETB's and PGP's NAV's since inception, which does not include dividends and distributions.

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I hope this article sheds some light as to the ridiculous valuation assignments that CEFs sometimes receive and the misplaced popularity that some funds and fund families earn. PGP has obviously been a great bull market fund for investors over the past two years but frankly, PGP would not have had such a great return from the market lows in March of 2009 had it not dropped so much in the year and half prior to that.

I know a lot of investors are going to rush to defend PGP so let me say this. PGP's advantage is that it has a mostly bond portfolio and certain bond sectors can be less volatile and hold value better even when equities are under selling pressure. Combine that with PIMCO's superior fixed-income management and I would be the first to buy PGP if it cut its dividend and traded close to par. While there are so many better opportunities out there, I am willing to wait until that day.

Finally, I would like to comment about PIMCO's and Eaton Vance's management. One is loved and the other is loathed. Just so we are clear, I am no fan of Eaton Vance's management and there is no question that PIMCO has superior fund managers. But that's not the point because that advantage is severely diminished when the market environment goes against PIMCO's highly leveraged funds and favors the more defensive Eaton Vance option-income funds.

I do believe that Eaton Vance has some excellent CEFs that are not being appreciated at all by the markets. I have tried to convince Eaton Vance of taking some steps that I believe would make their option-income funds in particular more attractive to investors. The first would be to reduce their Return of Capital (ROC) percentages. This is actually a much easier step than investors realize in option-income funds. All Eaton Vance would need to do is take capital gains either by letting the options expire or taking appreciated gains in equity positions and voila, ROC goes down. I believe they are starting to do this with some funds as evidenced by ETW and ETV which both had significantly reduced ROC percentages in their latest distribution. ETW's was in fact 0% ROC.

The second step I believe Eaton Vance should take is to change the investment strategy for one of its funds, ETJ. ETJ is an option-income fund that also buys 100% put options for further downside protection. Unfortunately, the fund has not shown that it can grow its NAV in any market environment, even a down market environment in which it should excel. I believe Eaton Vance would be wise to simply drop the buy put option component since the fund's ramp-down market price and NAV performance has, I believe, cast a pall over its other option-income funds.

Disclosure: I am long ETB, ETW.