Written by Nick Ackerman, co-produced by Stanford Chemist
John Hancock Hedged Equity & Income Fund (NYSE:HEQ) is designed to provide diversification across equities. They then employ an option strategy intended to keep downside limited. The fund is rather small and hasn't had much success historically. Though this could be due to its larger exposure to financials and investments outside of the U.S. The biggest draw for the fund is the current discount and almost 10% distribution yield. The other additional appeal for this fund would be that it is invested in a rather unique portfolio - the top ten holdings aren't typically held elsewhere.
(Source)
The fund's investment objective is for "capital appreciation and current income." They highlight the "use for" as a "diversifying source of income." To achieve this they will "invest at least 80% of the portfolio in a diverse selection of equities across market capitalizations." Though it seems that most of their larger positions are in well-known large-cap names. Additionally, they listed a whopping 780 positions. Meaning they certainly are diversified, at least in their approach to different stock holdings.
They will then employ an option strategy. In the case of HEQ, it involves writing calls on indexes. The fund last reported several option index positions; Euro STOXX 50 Index, FTSE 100 Index, MSCI EAFE Index, and S&P 500 E-mini. With these, they have several positions in "forward foreign currency contracts." This is additionally where they are hedging their portfolio, which is another derivative contract like option that can be used in specific ways.
We can also see that they are using other futures contracts and swap contracts. So a lot is going on here under the hood. Though even for all this complexity, the biggest factor is the underlying portfolio and how it is performing.
(Source - Semi-Annual Report)
Total managed assets of the fund stand at just $160 million, making it a pretty small fund. This can cause liquidity issues if a larger investor needs to get out right away. The expense ratio for the fund is 1.14%. This is surprisingly low for such a complex and small fund. This seems more than reasonable for a global fund with plenty of derivative shenanigans.
Performance - Relatively Weak Performer
Over the longer-term, HEQ has performed more in-line with a bond portfolio. Below is a chart representing the last 10-year period of performance between HEQ and SPDR S&P 500 ETF (SPY) and Vanguard Total Bond Market Index ETF (BND) for context.
This could be just a mere reflection of its defensive nature "dragging" down performance for the fund. After all, "hedge" is in their name so we will need to see how it performed in the recent selloff in March of 2020 relative to these passive ETFs.
The dates we are looking at specifically are February 19th, 2020 to March 23rd, 2020.
From what we can see above, HEQ did mitigate some of the downside relative to SPY. In fact, I'm surprised it did so well relative to this ETF. The reason being that the highest exposure they have is to financials. As we know, financials performed even worse in that period due to their economic sensitivity.
The Financial Sector SPDR ETF (XLF) declined 42.79% in that same period. SPY, for a friendly reminder, is mostly composed of tech - to quite a significant degree.
(Source - Fund Website)
So relative to a heavier financial portfolio, I would say that HEQ probably didn't do too bad of a job. That being said, they classify and benchmark themselves as a "closed-end world large stock." Using those benchmarks that they provide, the fund does a poor job.
(Source - Fund Website)
One area that the fund does have going for it a bit is the current discount. At a 10.26% discount, this compares favorably to its average discount over the last year of 9.40%. Even more favorably when we look over the last 5-year period coming in at 5.33%.
The fund has even on a brief couple of occasions touched premium levels. Though this 10%+ discount is more common historically than a premium is.
(Source - CEFConnect)
Distribution - High Yield, But Past Performance Doesn't Support It
One of the other selling points of this fund would be the 9.97% distribution yield it is currently sporting. On a NAV basis, this works out to an 8.85% yield. However, as we can see from the performance metrics above, the fund has never supported this high of a yield. It has resulted in a decline in share price since its inception in 2011.
What we would typically see here is that a distribution would have been cut several times. Though they have only cut their quarterly distribution in 2020. Instead of adjusting as needed, they allowed assets to erode. This can be great for income investors, but eventually, something has to give, either a significant appreciation in the underlying portfolio or a distribution cut.
(Source - CEFConnect)
Typically, in an equity-focused fund, we will see a considerable amount of the distribution coverage via appreciation. This is no different for HEQ; we see net investment income [NII] coverage come to a slim 28.5%.
(Source - Semi-Annual Report)
They were sitting on roughly $14.8 million in unrealized appreciation on the books at the end of 6/30/2020. Total assets at that time were $146.782 million. Now that assets have rebounded to the $160 million mark, this situation has improved. However, we are looking at about breakeven almost and still not having any gains on the books to harvest for the distribution needs. As long as the overdistributing goes on, the harder each subsequent payment will be to cover.
The tax character for the prior years of 2019 and 2018 can be seen below.
(Source - Annual Report)
In 2018, the return of capital [ROC] portion of the distribution was destructive. However, in 2019, NAV started the year out at $14.46 and ended the year at $14.85. Meaning that the ROC wasn't completely destructive, but still was somewhat. On a rough estimated per-share basis, ROC would have been ~$0.83 per share of the total ~$1.50 in annual distributions it paid out. NAV only increased $0.39 for that year - thus, anything over that amount would technically be destructive.
Holdings - Overweight Financials And Global Stocks
As we touched on above, we see that the financial sector is the largest allocation - though it isn't overwhelmingly so. We also see that they are comprised of 43.14% of U.S. holdings at the end of January 29th, 2021. The remainder in various countries around the globe. This also helps keep them more diversified. I'm even quite optimistic about financials and global stocks too, as their valuations are attractive at current levels.
However, I'm not sure this fund has an appeal for playing the rebound. I believe their hedging strategy is keeping their performance down and should continue to do so. Thus, limiting the upside if one is optimistic on these areas of investing as well. Even being overly active with a portfolio turnover of 125% in 2019 didn't lead to better results for the fund. Though in 2015 and 2016, this was much lower at 43% turnover.
If an investor is interested in this fund, one last thing they have going for them is that their top holdings aren't typically found elsewhere. They are even mostly well-known large-cap names. Though with their turnover being so high, I wouldn't expect this to be long-term positions of the fund. They also listed that they had 780 holdings as of December 31st, 2020. That is a significant amount for a mostly equity portfolio. Though I've seen an even higher number of holdings on high-yield funds before.
(Source - Fund Website)
The three financial positions that actually show up in their top holdings are AXA SA (OTCQX:AXAHY), UBS Group (UBS) and Bank of America (BAC). UBS is a financial services company that operates out of Switzerland. Most investors will know that BAC is also a bank, with operations as an investment bank and other retail services.
The company that I wasn't so familiar with until I looked it up was AXAHY. They are a French insurance and asset management company.
Verizon (VZ) and Philip Morris International (PM) are dividend investor favorites. Which, we don't see in a lot of CEF portfolios, at least not at such significant amounts to be in the top ten.
VZ has been growing its dividend for 16 years now (despite what the chart might be actually showing below.) We can verify the information from VZ's investor relations website.
(Source - Seeking Alpha)
PM is showing dividend growth over the last 12 years. However, it was spun-off from Altria (MO) in 2008. Which MO itself has shown 51 years of dividend growth.
(Source - Seeking Alpha)
Conclusion
HEQ offers an attractive discount, a high distribution yield and an interesting portfolio from mostly tech-heavy funds. However, the lack of performance and distribution coverage means that the appeal of these other favorable metrics is diminished.
This is likely to be the case going forward as well. As their "hedges" will keep them with limited performance. With the various derivatives they use, it can make the portfolio more complex than it is really helping. Though under certain conditions it can prove beneficial, it takes quite a bit of market timing. And market timing requires consistency. The fund might have more appeal for those wanting to time the market themselves, or use the fund for more of a tactical position. That being said, its small size is limiting and could cause issues for a larger investor - if they need to get in and out of trades quickly. For these reasons, I believe the case for owning HEQ is quite small and could probably be best to be avoided.
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