EOS: Another Strong Year Of Performance, ~6.7% Distribution Yield

Summary

• EOS is an equity fund with a covered call option strategy to generate additional "income."
• The fund uses the Russell 1000 Growth as its benchmark, making it lean into some midcap names but mostly large-cap.
• Investors got another strong year of performance out of EOS, and they were rewarded with a strong distribution boost midway through 2021.
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Written by Nick Ackerman, co-produced by Stanford Chemist

Eaton Vance Enhanced Equity Income II (NYSE:EOS) has been a strong performing covered call writing fund from the Eaton Vance group. Since they use the Russell 1000 Growth Index benchmark, we see heavy exposure to tech. Even more so than we see in other diversified funds that benchmark against broader indexes. This has contributed to the strong performance we've seen in EOS over the last few years now.

This fund is different from the usual Eaton Vance call writing funds since they write against single positions, so it is a covered call writing fund. Most of the others focus on writing options against indexes. We covered this topic more in-depth in the past.

However, the main difference is that you can't directly own an index, so it will be cash-settled when writing calls against an index. It also means theoretically that writing calls against indexes could have infinite losses as indexes can rise forever. We all know that isn't going to be the case in practice. Additionally, index writing funds will substantially overlap their underlying holdings with the indexes they are writing against. That means the underlying positions should be rising about the same to offset what could be infinite losses.

All that being said, with EOS being a covered call writing fund, it means they hold the underlying positions that they are writing against. That means no infinite loss potential for the fund. It also means they collect premiums by writing these calls and boosting the fund's "income." When writing covered calls, you generate capital gains - not what would be classified as income - but in the CEF space, they can take those gains and pay them out regularly through the year to investors. Equity CEFs wouldn't pay out nearly the amount they do now without capital gains.

EOS has become a bit more expensive since the last time we covered it, with the premium rising a bit more. However, a premium for this fund isn't that unusual. Instead of buying all at once, I believe this fund remains a position that you can dollar-cost average over the years. However, be mindful that this fund is right near its all-time highs.

(Source)

The Basics

• 1-Year Z-score: 1.76
• Premium: 3.67%
• Distribution Yield: 6.76%
• Expense Ratio: 1.09%
• Leverage: N/A
• Managed Assets: $1.184 billion
• Structure: Perpetual

EOS's primary investment objective is "to provide current income, with a secondary objective of capital appreciation." To achieve this, "the fund invests in a portfolio of primarily large- and mid-cap securities that the investment advisor believes have above-average growth and financial strength and writes call options on individual securities to seek to generate current earnings from the option premium."

They typically target around 50% of their portfolio being overwritten. The less the portfolio is overwritten, the more positions left to "fly higher" in a bull market. As we know, utilizing a covered call strategy in a bull market can generate lagging returns relative to a non-option strategy fund. As assets are rising, the underlying positions either get called away, or they have to close the position that can result in some losses.

For this reason, while they use the Russell 1000 Growth Index as a benchmark, we won't see this fund outperforming in most periods. Over the longer run, it will typically underperform this "benchmark." That is often the case with most of these call-writing funds. So when seeing these funds, think of benchmark as an idea of what the underlying holdings will sort of line up with, not expecting to outperform it.

These funds work best in a mostly flat market. They can also work in a market that might be slightly downward too, as it is a somewhat defensive strategy. These instruments are for generating regular distributions to shareholders, and for that, they do a stellar job.

This fund is sizeable, and it doesn't utilize any leverage. That's at least one less worry that we don't have to be concerned with during times of panic selling. That being said, as an all-equity fund, during times of panic, this fund can take significant losses. The discount/premium mechanic can magnify that in CEFs. Generally, that's when opportunity strikes and should be seized.

Performance - Strong Results

The fund has delivered solid returns to investors for more than the last few years mentioned above. Since this fund launched, it has mostly done well. It just really ramped up materially in the last few years as the tech sector and the rest of the market has shot up. Below are the returns since the end of November 2021.

(Source - Fund Website)

Tech wasn't quite the hottest thing in 2021 as it was in 2020 and 2019. That being said, it still performed exceptionally well, which translated into EOS performing strongly for the year. More than enough to cover its distribution and merited the distribution boost in the previous year.

Data by YCharts

One of the more noteworthy things about EOS is that it is near its all-time high. This fund was launched in early 2005, so it went through the 2008/09 great financial crisis. That period saw massive losses for equity CEFs across the board. Most CEFs have never recovered from that point, even after all this time.

Of course, that's because they pay out most of their earnings to investors and can't retain them to grow. I don't view a fund negatively if they aren't above their inception price, but I think it is just a bonus that EOS was able to. It also helps that the fund wasn't leveraged, so the losses during that time weren't permanent.

Data by YCharts

At this time, the fund is trading quite richly. However, this has been a common theme going back to around 2016. Since 2016, the fund has regularly traded at premium levels. I believe that the strength can continue, too, as the fund seems to have become more popular with income investors.

(Source - CEFConnect)

That being said, the current 3.67% premium means it's over the 1, 3 and 5-year average trading level. Utilizing a dollar-cost average could be more appropriate until we get a dip.

~39% Boost In The Monthly Distribution

Investors in EOS and several other EV funds received good news in 2021. We got distribution boosts that seemed to be well overdue. For EOS, it went from $0.0988 to now $0.1373 paid monthly. Good for a boost of nearly 39%.

However, it is still below the highwater market of its initial $0.144 distribution amount. Even despite the fund being at all-time highs. I think they are being more conservative here with their payouts. Still, it was a sizeable boost and pushed the fund's distribution yield to a more respectable level.

On a share price basis, the distribution rate comes to 6.76%. Due to the slight premium, the fund has to earn 6.91% on a NAV basis. That's a reasonable and seemingly sustainable level.

(Source - CEFConnect)

When I said this fund needs capital gains to fund its distribution, I wasn't joking. In fact, the fund generates a net investment income loss. That means the whole distribution is going to be covered by capital gains. In some cases, it is "covered" through unrealized gains. That was the case in 2020 where they didn't realize a gain either but had a NII loss and realized losses. Yet, the fund still performed incredibly well, and both the price and NAV rose for the year.

For the six months ended June 30th, 2021, they had sizeable realized gains compared to the 2020 fiscal year. Enough in gains to cover the distribution considerably. Though still reported a NII loss.

(Source - Semi-Annual Report)

You can have negatives show up for NII because the underlying portfolio doesn't pump out a lot of dividends on its own. With meager total income coming into the fund, the expenses eat up what little there is.

On that note, that isn't the only way that EOS has been growing. Since the fund has been trading at a regular premium, that has resulted in their at-the-market and dividend reinvestment plan creating new shares. Since it is done at a premium, that is accretive to current shareholders. Due to the massive size of the fund, these haven't contributed massively. Yet, it still didn't hurt those shareholders who are already invested in the fund.

(Source - Semi-Annual Report)

For the tax character of the fund, this is a perfect fund to highlight return of capital. As we already touched on above, the fund did well in 2020. Except, they only realized losses, and their income also was negative. In this case, it was still covered through the unrealized gains, and the ROC shown wasn't destructive.

It was just simply that the portfolio itself didn't realize enough NII or gains to fund its distribution. Yet, it was "earned" on the basis that the fund NAV still rose.

(Source - Annual Report)

EOS's Portfolio

This fund is fairly active in trading around positions. The fund last reported a turnover of 14% for the six months. Even annualized would be on the lower end of the last few years. In 2020, we saw a portfolio turnover of 38%. In 2016, it was a 5-year high of 58%. At the same time, many of the top positions stay mostly the same. They are the mega-cap MAMAA names.

Additionally, the tech sector continues to be a significant overweight relative to the rest of the sector exposure for the fund. They previously reported a weighting of nearly 43% for the period ending June 30th, 2021. That is quite similar to where they ended 2020, at a tech allocation of 42.5%.

(Source - Semi-Annual Report)

At the end of October, they had positions in each of the MAMAA names. Those names include Microsoft (MSFT), Amazon (AMZN), Meta Platforms (formerly Facebook) (FB) (will eventually switch to MVRS,) Alphabet (GOOG) and Apple (AAPL).

(Source - Fund Website)

The top ten carry considerable weight in the portfolio. While their "benchmark" might include around 500 positions - EOS is actively managed and only carries around 60 positions. That pushes higher allocations against much fewer positions; the top ten are almost 50% of the portfolio. That would translate into quite a bit of concentration risk, aside from the overweight tech exposure.

I would also note that most investors would categorize all of these top ten names as tech plays. Yet, the 49.49% allocation wouldn't align with the 42.8% in tech reported. That's because AMZN gets put into the category of a consumer discretionary stock. Still, the position will perform similarly to the rest of the richly valued tech names, despite its official classification.

When we last covered the fund, we saw the top ten holdings in EOS for the end of June 2021. These were the same exact holdings as then. They were slightly shuffled in a different order due to market gyrations.

Conclusion

EOS has been a solid performing fund. It has been delivering monthly distributions to shareholders since its inception. While those distributions have been adjusted to reflect different market environments, they have continued nonetheless. With the fund at its all-time high and the premium inching higher than average, now might not be the time to be picking up a massive position. On the other hand, if you are a long-term investor, dollar-cost averaging into a position over the next couple of years could make a lot of sense.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of EOS, MSFT either through stock ownership, options, or other derivatives. 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 was originally published to members of the CEF/ETF Income Laboratory on January 3rd, 2022.