ETY: Some Thoughts On CEF Risk And Return Of Capital
Summary
- The sustainable income portfolio seeks high income and capital preservation in a mix suitable for a new retiree.
- ETY is discussed as an example of a top-performing option-income equity closed-end fund.
- ETY is a solid choice for income with capital stability.
- I include some thoughts on risk factors unique to the closed-end fund space. One real but too often overlooked (CEF risk) and another that gets lots of attention but is poorly understood (Return of Capital).
This continues my series on creating a new portfolio of income investments designed to have a high payout with capital stability. I'll not repeat the details, but it is important to see this discussion in that context. Previous entries in the series (from oldest to newest) focus on FOF, THW, PDT, DIVO, CHI, and BLW describe the goals and objectives, particularly the FOF and BLW articles.
We already have one broad market, option-equity entry but today I'm going to look at adding another. It's a category that is very popular among CEF investors.
As a generalization (and like any generalization there are exceptions) there are two commonly used strategies for generating high levels of income for equity closed-end funds. The first is leverage. The second is getting income from option writing. Few funds use both strategies. Most option-income funds are not leveraged. For our objectives, high income and capital sustainability, the option-income funds are the more attractive alternative.
Eaton Vance Option Equity CEFs
Any discussion of option-income closed-end funds should start with Eaton Vance, which sponsors a broad array of Option-Income CEFs. If you find that array a bit bewildering realize they come in four categories which are reflected in their names:
- Covered Call Funds which sell call options on individual stocks held by the fund.
- Buy-Write Funds which sell call options on one or more stock indexes reflective of the fund's holdings.
- Diversified Equity Income Funds which sell stock index call options and invest in higher-dividend-yielding stocks.
- Collar Strategy Fund which has a single fund that buys index put options and sells index call options. This is a specialized, niche fund designed to perform well, or at least less poorly, during adverse market conditions.
There are important differences in how the categories approach the generation of income from option writing. I'm not going to tackle the whole set. Instead I'll focus on the diversified equity income funds, those that invest in higher-dividend-yielding stocks and sell call options on stock indexes to generate income beyond those dividends.
There are two funds in this category: One domestic, Tax-Managed Diversified Equity Income Fund (NYSE:ETY) and one global, Tax-Managed Global Diversified Equity Income Fund (EXG). As the names imply they are managed with explicit consideration for tax consequences and the most tax efficient pathways to generate income.
Global vs. Domestic: How Much Diversification Do We Get From the Global Portfolio?
I was going to start with a discussion of the diversification benefits of adding global equity exposure. I like to support assumptions like that (the sort of thing everyone knows, right?) so I went to InvestSpy's calculator to demonstrate those benefits. I was surprised by what I found there.
For 1, 2 and 5 years' (top to bottom) correlation analyses there are no meaningful differences between the domestic fund's - ETY - and the global fund's - EXG - correlation with the two major US domestic stock indexes. In selecting between these two funds we can drop any consideration of getting portfolio structure benefits from choosing EXG over ETY.
Discount Values
Both ETY and EXG have a discount at present: ETY at -3.50% and EXG at -5.26%. EXG's is a bit further from its average discount (1 year Z-score = 1.55) than ETY (1 year Z-score =0.97), but neither is what we might call bargain territory. It's a bit difficult to evaluate Z-scores in CEFs right now because we have been experiencing a months-long recovery phase from some extreme CEF discounts. I'm satisfied that the present discounts on these funds are no barriers to including either of them in our portfolio.
Distribution Rates and Histories
Nor do we have much difference in yield. ETY pays 7.82% and EXG pays 7.90%. Both are attractive for an equity fund and there's not enough difference there to drive a choice.
ETY does have a better record of maintaining its dividend which has held constant since the funds went to monthly payments in 2013.
By contrast, EXG has cut its distribution twice over the period (both charts extracted from CEFConnect).
Return of Capital: A Brief Consideration of a Misunderstood Topic
For both funds, the distributions are primarily from return of capital. There are SA authors who still point to this as a warning sign (see here for a recent example). But as most of my regular readers are, I'm sure, aware, return of capital is an accounting concept and a feature of a tax-managed equity account. It is not a shortcoming, not a harbinger of reduced distributions, and certainly not something that requires any sort of extreme caution when approaching a fund.
Return of capital is an accounting term. It does not mean principal value is being eroded to make the payouts. If that were the case, NAV would necessarily be declining because NAV is the fund's principal value. Tax-managed funds will be managed to include high levels of RoC in their distributions. Option-income funds are especially prone to this accounting factor because much of their income comes from option premiums.
There is a solid case for RoC as a desirable feature of equity funds: The component of a fund's distribution that is characterized as return of capital is not taxed as it is received. When the fund is sold, all distribution income that has been characterized as return of capital is deducted from the basis cost (your broker should take care of this transparently).
The overall effect is that for a fund that has been held for more than a year, the RoC payments receive the favorable tax treatment of long-term capital gains when the fund is sold. One risk to that is the occasional discussion out of Washington to remove the favorable long-term capital gains treatment (as many state income tax regulations do).
Readers looking for a fuller explanation should check out Eaton Vance's excellent discussion on the matter. This sidebar on key takeaways comes from that review of the subject:
One final word on the subject: Return of capital can be a red flag for fixed-income funds. A fixed-income fund with high and recurring levels of RoC may well prove to have issues maintaining its distribution. If the fund's income comes from dividends exclusively, return of capital can indicate a problem. Funds that make use of derivatives and swaps are more like the option-writing equity funds in that RoC comes with the accounting and may or may not be a matter of concern.
Be aware that I'm neither a tax expert nor an accountant, so if this is something you need help sorting out, your professional tax adviser should be your first stop.
NAV and Price Performance
As noted above, it's the NAV charts that will tell you if a fund's distribution is getting edgy. A declining NAV is the surest sign that things are amiss with the distribution. But NAV, like all portfolio values, does fluctuate; let's not confuse short-term volatility with dangerously declining NAV.
I'd normally start with a one-year chart, but current one-year charts start at the depths of the COVID drawdown and present a misleading picture, mainly painting a rosier picture than is deserved, so I'm going to a three-year chart for both funds. The three-year charts bracket the COVID drawdown and provide a better overview.
ETY has added 10% to its NAV and EXG has added 2.6%. Both are still pulling out of the deep drawdowns they experienced a year ago, and both are trending up.
Another point to notice on these charts is something typical of CEFs, the market-price drawdowns were much greater than those that hit the NAVs or the broad equity markets. This is because the selling pressure drove down not only underlying values of holdings, but added to the funds' discounts as well. Notice in the next chart that the drawdowns on NAV were in line with the drawdowns on the market index, while market-price declines were ten to fifteen percentage points lower.
Risk: Market Risk and CEF Risk
This is an important point: Closed-end funds have greater downside capture and greater market risk than ETFs or OEFs. They exaggerate every drawdown. It's not simply increased volatility, although that too is a factor. Volatility can cut both ways but CEFs truly emphasize the downside. They will often lag on the recovery as well. If you're the sort of investor who is unable to ride out market drops, especially severe drops such as last March's 30% fall, you should probably stay away from CEFs. I've been making this point in my last few articles. I think I'm going to refer to it as CEF risk.
The next table summarizes risk and return metrics for the two Eaton Vance funds and a set of comps. For comps I've chosen two Nuveen CEFs with a somewhat similar strategy of generating income from call-writing, in these cases the focus is on the S&P 500 with greater (BXMX) and lesser (SPXX) levels of option coverage. I've also chosen DIVO, an ETF I discussed in detail earlier (here). DIVO has a similar strategy as the Eaton Vance funds: Its portfolio comprises high-dividend picks and it finds additional income from call-writing. Its option coverage is less than any of the CEFs.
All three of the comp funds pay lesser distribution rates than the EV funds: DIVO, 4.9%; BXMX, 6.3%; SPXX, 5.9%.
SPY is included for a picture of the domestic market.
ETY leads all the funds in total return (distributions reinvested) although it does lag SPY. This is a strong performance for the long period covered (limited by DIVO's inception date). ETY and EXG bracket DIVO. The other two funds are behind by a large margin. We can't blame their second-tier performance on paying out high income, because they don't; their distribution rates are the lowest of the CEFs. In any case the total return metric would account for income.
But the point here is the risk metrics, not returns. All of the CEFs show high volatility. The fact that the two S&P 500 option-income funds have higher volatility and greater Daily Value at Risk than SPY underscores my point above on the enhanced market risk of CEFs. Consider that these three funds are drawing from the same assets. Then consider that call-writing funds are expected to be more stable than straight long-equity funds.
It is acknowledged that they will have reduced market returns due to the cap on gains imposed by call writing, but that is supposed to come with a more defensive posture in the face of down markets. These data fly in the face of that assumption. But that failure to meet expectations is only true for the CEFs; DIVO does what the conventional wisdom predicts. This is CEF Risk.
ETY and EXG lead the field in the risk metrics except for the advantage ETY has over SPXX on max drawdown. But at least they turn in a strong showing on return. The index funds fail to do even that.
It's easy to see the appeal of DIVO here. Total return over nearly five years is second place trailing the top CEF by four and a half percentage points. But the risk metrics are the best on the board, SPY included. Of course, DIVO gives up income to the rest, where passive income is a primary goal it loses points on that count. Once we put in the income advantages the two Eaton Vance CEFs offer, it should be clear why I like ETY in this category.
But I will add that the conservative investor would likely be better served with DIVO than any of the CEFs here.
ETY Is Today's Pick, But Only Just Barely and We're Not Done Yet
Based on this analysis, I'm going to choose ETY over EXG. Both are paying about the same distribution. Both have moderate discounts although there's an edge to EXG on this metric. And both have near-identical impacts on portfolio balance. ETY is less volatile and an overall better performing fund which makes it the clear winner in my view.
I'll leave it here but I'm not through with this category yet. I know the option-income equity funds are very popular among CEF investors, so I'll continue with the category shortly. I like ETY, it's a fund I've owned in the past and it's been good to me, but I'm not quite ready to add it to the sustainable income portfolio quite yet.
Analyst’s 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.
This article does not constitute investment or tax-planning advice. I am passing along the results of my research on the subject. Any investor who finds these results intriguing will certainly want to do all due diligence to determine if any fund mentioned here is suitable for his or her portfolio. And, any investor who has concerns about the tax status of an investment will want to consult with a tax professional on that topic.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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Comments (70)
EATON VANCE TAX MANAGED
BUY-RITE OPPORTUNITIES
FUND
2,698
$15.8810
-$0.0490-0.31%$42,846.94
-$132.20
+$12,441.50
+40.92%
03:03 PM ET
Action for symbol ETV popup
+$12,441.50 +40.92%ETY popup
EATON VANCE TAX-MANAGED
DIVERSIFIED EQTY INCM FD
1,869
$13.35
+$0.06+0.45%$24,951.15
+$112.14
+$7,235.31 +40.84%
03:07 PM ETOne them both 10 + years
Allday
Its done well for me and appears to have better performance than the others mentioned.
Would appreciate your opinion of ETG relative to the others if you have a chance.
Maybe NUSI? A long/short fund that uses derivatives to generate current income with downside protection. I don't know much about it. Some people have recommended it but my quick look (emphasis on quick) didn't lead to any kind of follow up.
Good luck with it. It's one of my current favorites. I like DGRO in the category but its a dividend growth fund with quite modest income.
What do you think about QYLD?
Since I am not very familiar with options, I use the fund managers' expertise.
I been asked about QYLD a lot. I'm not a fan. Just off the top of my head, and memory, its high yield comes at a cost to capital. Not something I'm interested in. QQQX is a better call in my view.
QQQX QYLD Growth of $10,000.00
With Dividends Reinvested
Click for detailed chart tool
Start date: 12/12/2013 12/12/2013
End date: 04/06/2021 04/06/2021
Start price/share: $17.20 $25.04
End price/share: $27.78 $22.78
Starting shares: 581.40 399.36
Ending shares: 966.65 785.41
Dividends reinvested/share: $10.85 $15.73
Total return: 168.54% 78.92%
Average Annual Total Return: 14.45% 8.27%
Starting investment: $10,000.00 $10,000.00
Ending investment: $26,849.68 $17,886.44
Years: 7.32 7.32
That's huge. I knew QYLD was problematic but that's really extreme.
Am bookmarking
Thank You
EV used to make it easy to see the previous years actual RoC. They started making it difficult a few years ago. About the same time RoC was routinely less than they were reporting on the monthly notices. Another pet peeve of mine is that RoC is often overreported on the monthly notices. Which is fine, I suppose. But it's never corrected for the record. Sites like cefconnect, morningstar, et al. continue to retain those monthly figures forever even when they bear no resemblance to the actual reported RoC at the end of the year.
Morningstar publishes an upside and downside capture ratios. For the last year ETY has greater upside capture (80%) than downside capture (72%) but that's not the case for 3. 5 or 10 years.
I'm not a fan of ETJ. I know lots of people have made money on the fund and it has its following but it only outperforms for brief periods in declining markets. Even that is problematic because to get the full benefit means you have anticipate the declining market ahead of time. It's the poster child for declining NAV otherwise (-27% in 10 years).OTOH hand last time I looked at it, it had a high distribution rate.
Yes. None of it matters in a tax-advantaged account. All gains are treated the same: No taxes until you take money out (traditional IRAs of various flavors) or no taxes ever (Roth). It's in taxable accounts that it matters.
based upon 4/6/2021 close
Shares1,869
Starting price 9.48 value 17,715.84
Yesterday's price 12.97 Value 24,240.93
Total increase 6,525.09
Gain/Loss (%) ascending + 36.83 Directly off my brokerage statementBuy, leave alone SWAN.Allday
Yep, but to be fair a blind pig would have made money in domestic equity since 2017.
2010 is about the time I started with these funds. EV's option-income funds were among the first CEFs I owned.
That makes three of us.
ETY is my largest CEF holding. Douglas Albo was publishing articles about the EV option income funds at that time. Many of us retirees have become very knowledgeable about CEFs thanks to Douglas Albo and Left Banker
I agree, it is an exceptional fund.