Fund Spotlight: ETJ - A Fund That Has Performed Well Through The Crisis

Summary

• ETJ is a unique CEF in that it employs a collar options strategy to a portfolio of stocks.
• That collar strategy is meant to protect on the downside while producing income by writing calls.
• The fund has held up well during this crisis and has acted more like a bond fund than an equity fund.
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We screen the top funds on a NAV basis year-to-date, one-year, and three-year quite frequently, for obviously reasons. This is especially the case in times when the market sees significant volatility as those instances provide great insight into the positioning of the portfolios.

One of the best funds this year has been Eaton Vance Risk Managed Diversified Equity (NYSE:ETJ). We've highlighted this fund a lot in the last few years as it's a unique strategy allowing investors access to the S&P 500 with downside protection and an attractive yield.

Fund Characteristics

• Total Assets: $607M
• Leverage: 0%
• Management fee: 1.0%
• Avg. Daily Volume: 264K
• Avg. Daily Volume $: 2.37M
• Distribution rate: $0.076
• Distribution frequency: Monthly
• Discount: -1.2%
• 3-year Avg. Discount: -3.2%
• 1-year Z-score: -0.30

What does the fund do?

It invests in a diversified portfolio of common stocks - about 53 of them in total - across their $607M in total assets. The stocks are primarily large-cap US equities of name-brand companies. The mega caps occupy most of the spots in the top 10 holdings list - a list which constitutes over one third of the total portfolio.

(Source: Eaton Vance)

But in addition to holdings those stocks - which by itself is nothing special - it writes call options on the S&P 500 to generate income. Those are typically called covered calls and is a common strategy for increasing your yield on your stock portfolio. This also is not very unique as there are dozens of funds including ETFs, and open-end mutual funds, that employ that strategy. The more unique aspect of the fund is that they also buy put options on the S&P 500 to reduce the downside risk - also called a protective put.

This is called a collar strategy. You cap your upside and limit your downside based on which options you buy. There are typically two different reasons why an investor might choose the collar strategy:

1. To limit risk at a "low cost" and to have some upside profit potential at the same time when first acquiring shares of stock.
2. To protect a previously-purchased stock for a "low cost" and to leave some upside profit potential when the short-term forecast is bearish but the long-term forecast is bullish.

By employing this strategy, it makes ETJ one of the lowest risk funds to own in the entire equity CEF space.

This fund writes calls and buys puts that are "out of the money" meaning that in order for you to be able to exercise the options, the price of the stock needs to either move higher (in the case of the calls) or lower (in the case of the puts). This also is sometimes called a "loose" collar as there's some wiggle room in what the price can do.

(Source: Annual Report)

The amount of the options on the underlying index amounts to 96% of the total portfolio. That means that 4% of the portfolio is free floating and not covered by the options strategy.

We can see the notional value of the purchased put options. Notional value is the value of the options if they were to be exercised. In this case, how much of the S&P 500 value we can sell if they were in the money. Total value of that notional value of the put options below amounts to approximately $582M. But you can see that the actual value of the options is just $1.36M. In other words, if they went and sold the put options as of their last annual report, they would net $1.36M.

The table below shows how they roll a similar-sized amount of options each month to have a staggered expiration date as they use weekly options on the index.

(Source: Eaton Vance Annual Report)

The same is true of the call options which have a similar notional value but a much different option value. This always should be true because the put options have a lot of value - i.e. the index has fallen - the call options will not be worth much and vice versa.

Distribution

The distribution has been remarkably steady given the managed distribution policy ("MDP") that the fund has adopted. Remember that in these types of policies, the fund team has targeted a specific yield on NAV for the fund. Some fund sponsors are more literal in their interpretation of this and adjust the distribution fairly often. Some do not. In the case of Eaton Vance, they have only adjusted it once in early 2017.

Also, with an MDP, you are obviously not earning that distribution. This is a stock portfolio and the dividend yield on the S&P 500 is a mere 1.9%. Even if the fund were to employ leverage, which it does not, it couldn't get to 9%-plus. And typically option income is decent enough to juice the yield on funds but this fund strategy, in addition to selling calls, buys puts. There's a cost to that which means that net credit from their strategy is likely minimal if anything. So what do they do?

When a fund pays an MDP, they are likely paying out some of your principal back. That can be in the form of "gains" or "return of capital." Either way, you are getting back principal instead of net investment income. The goal is to generate consistent gains from the stock portfolio so that the fund can "sell a few shares" each month and pay out without having the NAV of the fund go down much. When the NAV does go down enough, that's when you typically see a fund sponsor reduce the distribution.

(Source: CEFConnect)

Performance

So how has the fund done over both bull and bear markets? I consider most investors in CEFs buy and rent meaning they tend to hold on to most positions for longer periods of time but not forever. This fund is not a trading tool in that you position yourself in it at the end of cycles or if you think the market is going to plummet in the near term. The price will still fall like the vast majority of the rest of the CEFs in your portfolio. It did in February and March, falling 29% on price and over 10% on NAV.

Data by YCharts

Why did the NAV fall 10% when you have a collar strategy on?

There could be several reasons for that. For one, the put options are out of the money. Depending on how far out of the money there is a gap there before the "protection" of the put kicks in. When buying put options for downside protection or "insurance," I like to call the gap between the value the share price is at today vs. the strike price on the option equivalent to the deductible on insurance.

Second, the put options only cover approximately 96% of the portfolio. That means that the remaining ~4% are fully exposed to the downside of the market.

Third, the fund buys individual stocks and then writes options on an index. This can create a mismatch in the hedge as the ~51 positions could have tracking error compared to what the underlying index does. In other words, the stock positions fell by more than the S&P 500.

Overall, performance has been mediocre. In boom times it lags significantly, owing to the price it's paying for the downside hedge. In bust times it outperforms thanks to that hedge. It will still likely lose money in downturns but it will lose far less than other equity strategies. You can see that in the chart below. ETJ outperforms a few other EV covered call strategy funds by a wide margin.

Data by YCharts

Concluding Thought: Why You Would Buy It?

The best way to think of the ownership of a fund like this is as a bond substitute. What do I mean by that?

Future returns from your bond portfolio are likely to be much lower than they have been in the past owing to much lower interest rates today. As such, you may want to venture out the traditional fixed income style box and into more esoteric areas of the market. That includes alternatives that act like more traditional bonds but give a better return profile.

Many endowments, pension funds, and foundations have done this over the last few years to increase their returns in this low interest rate environment. They primarily use hedge fund ("lp") structures to gain that access as they can lever up a bit to further increase returns.

ETJ is giving you that kind of profile- sort of. The downside risk is still fairly significant for a "bond" fund with a 10% drop, especially when you compare it to the primary bond index, the Barclays US Aggregate Bond Index. Here we are using the iShares Aggregate Bond ETF (AGG) as a proxy. You can see it fell just 1.06% from peak to trough. That's because nearly half of the index is Treasuries which bounced nicely during this time as interest rates plummeted.

Data by YCharts

But using a more traditional bond fund like PGIM Total Return (MUTF:PDBAX), an advisor favorite, the fall in ETJ's NAV is more consistent with real bond returns. While volatility is a bit higher on NAV than most "total return" bond funds, ETJ does act like a bond substitute. That's also borne out by the returns achieved over the last 10 years. The total return annualized has been about 4.4% (7.07% annually over the last five years). That's very consistent with unlevered bond portfolios.

But the correlation to the bond index is just 17%. So the fund can achieve some bond-like returns with very low correlation to the index.

If that's the kind of exposure you want/need in your portfolio, then this is probably the best fund in the CEF space for that. The fund typically trades near par but, on occasion, you can grab some at a modest discount. I would say to buy at least at the three-year average discount of -3.2% when acquiring shares.

Analyst’s Disclosure: I am/we are long ETJ. 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.