- ETJ is an option-based CEF that is uniquely positioned to provide protection against market downturns.
- The mechanism is an option collar strategy.
- ETJ's implementation of the collar strategy is more management intensive and more responsive to market changes than that of NUSI, an ETF that employs a coarser version of the collar.
- ETJ's successes during drawdowns are much more evident at NAV than at market pricing. This is due to shareholder tendencies toward panic selling in a market downturn despite owning the only fund that is designed to function best in precisely those conditions.
I recently discussed Nationwide Risk-Managed Income ETF (NUSI), an ETF that employs an option collar strategy to manage and moderate downside equity risk. NUSI is a young fund having only been in existence for 14 months. There is a much more mature CEF (closed-end fund) that has been using the option collar to manage equity risk for nearly 14 years, which is a sufficient period to have been tested multiple times by market downturns. That fund, Eaton-Vance Risk-Managed Diversified Equity Income Fund (NYSE:ETJ), is my subject today.
I’ll begin with a brief comparison of NUSI and ETJ. NUSI holds a portfolio that replicates the NASDAQ 100 Index and writes a single pair (short call and long put) of monthly index options on that index. ETJ holds a portfolio of selected stocks and writes pairs of weekly index-options on the S&P 500 Weekly Index (^SPXW) that roll three times a week. Thus, NUSI has a single collar for each option month. ETJ typically has about a dozen pairs (short call and long put) open at any given time.
The Protective Collar
The execution of an option collar involves selling calls (covered by the fund’s portfolio) out of the money which generates a premium that is credited to the fund. The strike for those calls sets a cap on how much the fund can gain. And, of course, the higher one sets that cap, the lesser the gain on the premium received. The other leg of the collar further involves the purchase of an equal number of out-of-the-money put options using part of the call premium to fund that buy. The put strike sets a floor on the losses that the fund will sustain in a market downturn. As each option expires, the fund can earn no more than the value of the call strike price plus the net credit from the bought and sold option premiums (the cap). By the same token, it can lose no more than the strike price of the long puts less any net credit from the premiums (the floor).
This image from Investopedia illustrates the collar's implementation:
With that introduction, let’s look at ETJ.
ETJ: About the Fund
ETJ is one of Eaton-Vance's stable option-based equity CEFs. I describe the covered-call (call-write) funds earlier (here and here) but put off any discussion on ETJ because it doesn’t fit with that group. It is the only one that does not only write calls. Call writing funds have unlimited downside along with a cap on upside gains.
ETJ’s Fact Sheet describes it as follows:
“The Fund invests in a diversified portfolio of common stocks and purchases out-of-the-money, short-dated S&P 500 index put options and sells out-of-the-money S&P 500® Index call options of the same term as the put options with roll dates that are staggered across the options portfolio. The Fund evaluates returns on an after tax basis and seeks to minimize and defer federal income taxes incurred by shareholders in connection with their investment in the Fund.”
At present, ETJ is priced with a 4.72% premium to its NAV and has a distribution rate of 8.39% (8.79% on NAV).
This analysis from PortfolioVisualizer gives a sense of how the fund has performed. I’ve set it up to contrast returns from ETJ at market and NAV as well as to NUSI, the collar-strategy ETF I discussed previously.
Over the period shown here, ETJ added value to its market price, going from a deep, pandemic-crisis driven discount to its current premium, so the market CAGR, although real, is deceptively high. The NAV return gives the best indication of how effective the fund’s strategy has been. NAV CAGR is 276bps ahead of NUSI. A key stat for a fund of this type is maximum drawdown. As we see, the NAV for this metric excels over a period that covers the Spring 2020, COVID-crisis downturn. I’ll be discussing this aspect in some detail later.
ETJ’s Portfolio and Approach to the Protective Collar Strategy
The top ten portfolio holdings are:
More interesting is the option holdings shown next. This is the most recently available snapshot of the fund’s option positions. The data are taken from the complete list of holding on the fund’s website and shows the holdings as of 31 March.
There is no indication of basis costs for these positions or the date they were opened, so it’s not possible to discern how much credit accrued to the fund from the call premiums. Nor can I tell how much out of the money the options were when they were opened.
But we can glean some useful information towards understanding how ETJ operates. We can see is how frequently the fund is writing options. SPXW has three strikes a week. In March, and presumably routinely, the fund was rolling positions for each of these dates. I’ve calculated the cap to floor spread for each date (right column) which was about all I could do with these data to get a picture of how the strategy is managed. Notice that it changed considerably over the course of the month, from as wide as 9.5% to as narrow as 6.6%. Unlike a fund such as QYLD, which follows a mechanistic, cast-in-stone approach to selecting option strikes, ETJ’s management is constantly responding to their read of the market and its volatility, and adjusting the option strikes accordingly.
This also distinguishes ETJ’s implementation of the collar from that of NUSI. NUSI writes a single monthly option pair to cover their entire portfolio. This gives up the possibility of adjusting to market changes any more quickly than that. ETJ management, by contrast, is making adjustments every two days.
Distributions and Valuation
This graphic, from cefconnect, shows ETJ’s distribution history beginning at the time it went from a quarterly to a monthly payment schedule. As noted, the distribution rate is an attractive 8.4%
Since the fund went to monthly distributions, there has been one distribution change: a – 17.7% cut from $0.093 to $0.076 in March 2017. Prior to that cut, the fund had been steadily losing NAV. In the four years since the distribution was cut, the fund’s rate of NAV decline slowed and has shown a turnaround to gains from mid-2020 through YTD. Indeed, ETJ, a fund that has historically carried a discounted valuation, is now well entrenched in premium territory (4.7%). This is hardly what one would expect from a highly defensive fund in a raging bull market.
How Defensive is ETJ?
This chart from PortfolioVisualizer shows the drawdowns of ETJ at market and at NAV along with the drawdowns of the S&P500 Index ETF, SPY.
The quantitative details of the drawdowns, described below, are especially interesting:
Key things to pay heed to are the different response from ETJ at market and at NAV. The fact that the defensive collar strategy generally works well is seen in the NAV table. Looking at the top two SPY drawdowns, we see that the Nov 2007 to Feb 2009 drawdown took SPY down -50.8% and lasted 14 months. ETJ’s NAV did not go into drawdown until June 2008 and maxed out at -9.99%, a remarkable performance that wholly validates the defensive, risk-managed option strategy. The length of the drawdown for ETJ's NAV was nine months. Even at market price, the fund bottomed at -12.8%. Apparently, there was sufficient selling pressure to drive even this fund, designed to protect against deep losses, down at market. But even so, there is a strong protective response.
SPY’s second deepest drawdown was Jan-Mar 2020 lasting only three months and bottoming at -19.43%. ETJ’s NAV was in drawdown for only two months (Feb-Mar) and bottomed at -3.65%. Compared to SPY having its second deepest losses at that time, ETJ-NAV’s -3.65% loss ranked seventh among its drawdowns. At market, the same trend is seen as in 2008, but the market decline was much deeper relative to NAV than it was in 2008 reaching -10.19%. Again, selling pressure drove down the market price, in this case sending the fund into a deep discount. In doing so, the fund lost much of the protective power it showed at NAV. The irony is that CEF investors in the fund had been giving up returns (relative to ETJ’s peer option-income funds) as the cost of that protection. Yet, they abandoned the fund in droves precisely when the event they paid protection against hit the market.
So, for the two worst market drawdowns of ETJ’s existence, the strategy worked (as seen by the NAV results) but was still widely abandoned at market.
I don’t mean to be condescending but I have a sense that CEF risk—by which I mean volatility driven by fluctuations in market-to-NAV valuations—is increasing as less knowledgeable investors flock to CEFs for yield without a real understanding of what they are buying other than an eight or nine percent distribution payment. Furthermore, I think this category of CEF investors has increased since 2008 as more people discover CEFs as sources of high income. Many may well be better served by some of the recent ETFs that have adopted strategies that had formerly been the province of CEFs, such as the option-strategies of NUSI and QYLD. The close tracking of NAV in ETFs will make it easier for buyers to stick with a strategy like ETJ’s when it is working and scared money is running away. Those watching a declining market price and a sharp deepening of the discount tend to ignore the nuances of NAV performance and panic sell, adding to the fire and generally doing themselves no favors.
ETJ has an excellent implementation of the protective collar option play. The quality of their approach is evident in the NAV returns, which are not distorted by market changes. In ETJ’s case, its very nature makes it especially susceptible to market distortions of its successful outcomes because the value of those outcomes comes at times when the market is especially driven by emotional reactions.
In my ideal world there would be an ETF managed like ETJ at NAV. Unfortunately, NUSI, the available ETF, takes the more easily managed shortcut of monthly options. Not to denigrate NUSI excessively, in its short life it has shown itself to be successful at implementing the protective collar, but it is not as successful as ETJ-NAV has been. One evident reason for that is its approach that makes it unable to react to market changes quickly, and, as we all know, the market changes that a protective collar strategy is meant to react to can happen very quickly.
My view of ETJ is that too many buyers either do not understand what they are buying and are selecting the fund primarily for its attractive distribution rate. Another set of buyers do own the fund specifically for its protective strategy but still panic and sell when the strategy they bought it for is put to the test. If anyone has another plausible explanation for the massive sell offs that drive the fund into deep discounts when it is doing exactly what it is supposed to be doing, and doing it well, please join the discussion.
Perhaps the best way to approach ETJ is to watch it when there is a sharp downturn and buy when the market valuation falls. The power of the strategy will likely show a speedier recovery, or it can sustain the fund through a long drawdown period. I would not be buying ETJ at its present premium valuation even though I see it as an excellent fund in the context of its objectives.
This article was written by
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.
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