Eaton Vance Covered Call Funds: Maximize Distributions Or Total Return?

|
Includes: EOI, ETB, ETY
by: ADS Analytics
Summary

We explore the performance of Eaton Vance funds ETY, ETB and EOI against their S&P 500 equity and buy-write benchmarks.

The funds have decided to use a buy-write benchmark that has delivered consistently inferior performance for over 10 years.

The reason for this, we believe, is that the funds have decided to maximize distribution rates in exchange for foregoing superior total returns.

A few weeks ago we wrote about Eaton Vance Tax-Managed Global Buy-Write Opportunities Fund (NYSE:ETW) - an Eaton Vance covered call fund that was beaten up at the time because of a distribution cut. The question we tried to answer, as we do in most of our fund-focused articles, was 'is this a decent fund?'

Now we'll be the first to admit that this is an almost philosophical question. There is no such thing as a platonic ideal of a fund that all funds should aspire to because investor utility functions differ, macro environments ebb and flow and fund characteristics change. For this reason we must settle for more pedestrian questions like 'does the fund generate alpha?' 'does the fund consistently outperform the sector?' 'how does the fund compare to its benchmark?'

These are all fairly dispassionate questions that lend themselves well to a quantitative analysis, something that we (try to) specialize in. Our conclusion, which seemed uncontroversial, was that the fund has historically underperformed the sector and its benchmarks while generating negative alpha. Shortly after, we got some pushback on the benchmark point, suggesting that, according to its annual report, the fund actually outperforms its benchmark. And sure enough, a quick glance at the report showed that that was indeed the case.

So what is going on here? Something clearly doesn't add up. What we argue below is that either the management team is (knowingly in our view) using the wrong benchmark to inflate its performance or it, for some reason, has actively chosen to follow a buy-write strategy with clearly inferior long-term total returns.

In this article we review three Eaton Vance covered call closed-end funds that:

  • Have S&P as the sole equity benchmark
  • Have a S&P 500 Buy-Write strategy as the sole Buy-Write benchmark

These funds are the following:

  • Tax-Managed Diversified Equity Income Fund (ETY)
  • Tax-Managed Buy-Write Income Fund (ETB)
  • Enhanced Equity Income Fund (EOI)

EOI is a slightly different animal from the other funds in the sense that it sells options on individual stocks rather than the S&P 500, but we thought it would be interesting to include it in any case given it still benchmarks itself against the index buy-write strategy.

Pick Your Benchmark, Any Benchmark

All EV covered call closed-end funds have at least one equity benchmark and one buy-write index benchmark. Equity benchmarks are usually the major indices like the S&P 500, MSCI World, etc. Buy-write index benchmarks come from the CBOE which has calculated historic total return indices on a number of buy-write investment strategies.

The three EV funds that we are looking at in this article are benchmarked solely against the S&P 500 as its equity benchmark and the CBOE S&P 500 Buy Write Index as its buy-write benchmark, also called BXM, which is a strategy that sells monthly ATM (or as close to ATM as possible) calls on the S&P 500.

As it happens, CBOE has come up with a number of different buy-write indices, not all of them against the S&P 500. The three most basic ones that apply to S&P 500 and relevant to this article are the following indices:

CBOE Index

Buy-Write Index

BXM S&P 500 Buy Write Index
BXMD S&P 500 30-Delta Buy Write Index
BXY S&P 500 2% OTM Buy Write Index

Source: CBOE

BXM, the EV buy-write benchmark, was the first buy-write index to be developed by the CBOE. The strategy sells ATM (or as close to ATM as possible) one-month calls. BXY, which sells 2% OTM calls followed in 2006 and from what we can tell BXMD, which sells 30-delta calls was introduced in 2015.

Let's see how these indices have performed. We include the SPY ETF in the chart as a reference.

Source: CBOE

The chart tells us three things:

  • BXM has 1) by far the worst performance and 2) consistently worst performance, both of which were clear pretty much from the beginning of the backtest
  • BXMD and BXY have similar performance
  • SPY has outperformed all three buy-write indices, although this was only realized against BXMD and BXY since 2015

The underperformance of BXM was explored in at least one study that was published in 2006, so it hasn't exactly been a secret.

So, the facts thus far are the following:

  1. BXM is, by far, the worst of the CBOE basic buy-write strategies
  2. EV, for some reason, has chosen to benchmark itself against BXM

Why would EV benchmark itself against a consistently inferior buy-write strategy?

We don't have a good answer but several possible explanations:

  1. EV, in bad faith, is actually following the BXY strategy but benchmarking against BXM because it is easier to outperform
  2. EV has decided that BXM is the better strategy despite its consistent underperformance, because for instance, it thinks that equities are more likely to range trade than to trend higher
  3. EV doesn't care about superior buy-write strategies - it only cares about outperforming the S&P 500 during periods of falling stocks - so selling ATM options is more likely to deliver this result than selling OTM options (because it can collect higher premia)
  4. Similar to 3, EV only cares about maximizing option premium because higher option premia translate into a higher fund distribution rate.

Obviously, EV does not disclose any details of its actual strategy, so we don't know which of the above is true or if there is another explanation that we are missing.

One piece of data we are able to gather is the actual moneyness of options that EV seem to be selling. This data is not very easy to get - EV does disclose the average moneyness of the options in each fund here but this information is useless because it does not tell us the moneyness of the options at the time of the sales which is what we really want.

The way to infer this information is to look at the form N-Q for each fund which outlines actual fund holdings. However, even there EV obscures what it is doing because it only includes the expiry date and strike of each option - however, we also need to know the trade date. Thankfully, we can infer the trade date because the CBOE indices work off monthly options. We can also calculate the moneyness by calculating the index forward via the index spot level on trade date, current interest rates and dividend yield. By our calculations, the last filing shows ETB sells options that are 0.40% OTM and ETY sells options that are 0.70% OTM. Obviously, this is only a single filing and we have not done this exercise since fund inception but it does suggest that EV strategy is closer to BXM than to the other two indices.

So this is a good-news bad-news kind of finding. EV does not seem to be doing anything in bad faith, at least not egregiously, but it is clearly choosing a strategy that has had consistently inferior returns. Which of the potential explanations 2-4 above is correct is unclear but we do suspect that the funds care more about maximizing distribution rates than long-term returns (after all, if you wanted to maximize long-term returns, you would just buy SPY rather than pay EV a 1% management fee for trying to replicate it via a complicated covered call strategy). A strategy designed to maximize distribution rates would obviously sell ATM rather than OTM options. In other words, it would follow the current BXM benchmark rather than the other two strategies with consistently superior long-term returns.

Let's now have a look at how the three funds have performed against the S&P 500 and the buy-write indices. We use NAV tickers (regular fund tickers bookended by 'X' for those unfamiliar with the NAV tickers) to avoid the impact of discounts.

Fund Deep Dives

ETY has underperformed SPY as well as the two superior buy-write benchmarks and outperformed BXM by about 1.4% per annum. Interestingly, however, ETY volatility and last 1Y drawdown are worse than all three buy-write strategies, suggesting that, perhaps, the fund has had a higher beta than the S&P 500. Against SPY, the fund has underperformed by 1.9% per annum; however, it has had a lower volatility and a 1Y drawdown that was 10% lower than the SPY during the financial crisis. Whether the 1.9% of underperformance was worth the lower price volatility and drawdown is, of course, for each investor to decide.

Source: ADS Analytics LLC, CBOE

Source: ADS Analytics LLC, CBOE

ETB has outperformed all three buy-write strategies since inception, outperforming BXMD by 0.1% per annum. Against SPY, the fund has underperformed by 1.1% per annum, although it has had a lower volatility and drawdown. The performance of ETB we actually find quite impressive given the high management fee, suggesting that ETB is actually outperforming the best buy-write benchmark by over 1% per annum.

Source: ADS Analytics LLC, CBOE

Source: ADS Analytics LLC, CBOE

EOI is slightly different from the other two funds in the sense that the fund sells options on single stocks rather than the index. That said, it still benchmarks itself against the index buy-write strategy. The fund has underperformed the two superior buy-write strategies while having a higher volatility and mixed drawdowns. Against SPY, it has underperformed by 1.9% per annum with a lower volatility and mixed drawdowns.

Source: ADS Analytics LLC, CBOE

Source: ADS Analytics LLC, CBOE

Conclusion

In this article we review the puzzling case of why EV covered call funds have chosen to benchmark themselves against a consistently inferior buy-write strategy. We don't have a good answer here and EV has not provided one. From looking at the most recent fund options trades, we suspect that EV care more about maximizing the premium it collects on the options rather than on long-term returns which it can pass on to investors in the form of distributions. This explanation fits nicely into the fact that the closed-end fund market trades more on yield rather than total return. Investors, therefore, have to make an individual decision of whether they wish to maximize distributions or total returns. Ultimately, the question for investors is whether to forego superior longer-term returns in order to maximize current distributions. The choice that EV made is clear.

Thanks for reading. In the coming weeks, we plan to launch Systematic Income - our Marketplace service on this platform. In addition to detailed analytics of CEF funds and sectors, frequent tactical screens and ideas, we plan to publish and discuss regular updates and performance of our systematic strategies. We hope you can join us.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is for information purposes only and does not constitute investment advice or an offer or the solicitation of an offer to buy or sell any securities. Past performance is not a guarantee and may not be repeated. Investment strategies are not suitable for everyone and you should always conduct your own research or speak to a financial advisor. Although information in this document has been obtained from sources believed to be reliable, ADS ANALYTICS LLC does not guarantee its accuracy or completeness and accept no liability for any direct or consequential losses arising from its use. ADS ANALYTICS LLC does not provide tax or legal advice. Any such taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.