ETJ - 8.5% Yield, Well-Contained Risk
Summary
- ETJ is a closed end fund that has current income as a primary objective.
- The fund employs an options collar strategy to extract yield from equities' upside and to protect the downside during market sell-off scenarios.
- The fund had a maximum drawdown of only -10% during the stomach-churning COVID sell-off in 2020 versus -20% for the S&P 500 (on a monthly measurement basis).
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Thesis
Eaton Vance Risk-Managed Diversified Equity Income Fund (NYSE:ETJ) is a closed end fund that has current income as a primary objective. The Fund invests in a portfolio of common stocks and purchases out-of-the-money, short-dated S&P 500 index put options and sells out-of-the-money call options of the same term. The Fund pays monthly distributions to shareholders pursuant to a managed distribution plan. The fund has a Sharpe ratio above 1 on a 5-year lookback period with a low standard deviation of 8. Trailing total returns are also robust clocking-in at 13.7% and 10.8% on a 5- and 10-year lookback periods. ETJ employs a collar strategy to generate the income it pays as dividend yield and to protect the fund downside from market sell-offs. With a modest NAV give-up of only -1.7% in the past decade, ETJ has proven a robust vehicle in the recent 2020 COVID sell-off. The major appeal of this fund resides in its very shallow drawdowns (as measured on a monthly basis) and low volatility. While currently trading at a small premium to NAV, we find ETJ attractive and are Bullish on the name. A savvy investor is well served to start slowly layering in and accelerating purchases once the price falls below NAV.
Collar Structure
What is a collar in finance you might ask. For the purposes of this fund a collar represents an options strategy where the fund sells out-of-the-money calls and buys out-of-the-money puts, usually for a zero-cost, depending on the option skew. What does this do, and please spell in out in English you might ask. Simply put, the fund sells most of the upside of the stock portfolio, while at the same time protects the downside performance via the rolling puts:
Source: Eaton Vance
Basically this strategy protects against large downside scenarios. As opposed to typical Buy-Write funds ETJ has an overall total return performance that resembles more closely the S&P 500, but obviously pays a significant dividend. So in a nutshell, layering this type of an option strategy allows the portfolio managers to extract yield (dividends) when stocks are increasing in price, while at the same time the downside scenarios are smoother versus "naked" (i.e. no puts purchased) buy-write funds. We will look closer at actual figures in the below "Performance" section.
Holdings
The fund falls into a large cap / large blend category. When looking at the top holdings we will find a number of familiar names:
Source: Eaton Vance
The fund is overweight Tech and Consumer Discretionary versus the index:
Source: Eaton Vance
Performance
ETJ has a good historical performance in the past decade, having lost money only during 2018, when we had a significant end of the year market sell-off:
Source: Author
I consider the 2016 as being flat for the purposes of this analysis given the sub -1% number. On a trailing basis the fund has also posted very robust figures:
Source: Author
Let us have a look on how ETJ does during a market correction versus the S&P 500 and another Buy-Write fund from the Eaton Vance suite, namely Eaton Vance Tax-Managed Buy-Write Income (ETB):
Source: Seeking Alpha
We have taken here 2017-2018 as a period of reference since we had a significant correction at the end of 2018. We can see here that on the way up ETJ tracks fairly closely for long periods of time the S&P 500 performance, while ETB lags. On the risk-off scenario ETB owns most of the downside while again ETJ and the S&P 500 exhibit similar performances.
On a longer time-frame (i.e. 5 years) we can see clearly how ETJ gives up the substantial upside the S&P 500 exhibits because of the continual cost of the puts as part of the collar:
Source: Seeking Alpha
Ultimately what ETJ does is extract dividend yield from stocks as long as they are maintaining a slightly appreciating price or going up substantially. The fund also pays a little more than it makes from the options strategy:
Source: CEF Connect
ETJ exhibits on a 10-year basis a -1.7% annual NAV give-up. This means that annually 1.7% of the dividend that is paid is actually return of capital, or principal balance. This is not ideal, but at the same time it does not constitute a very large figure. The higher this number the less reliable a fund is, since it clips management fees just to return investors their own cash.
What is the appeal for ETJ?
ETJ exhibits a very conservative drawdown scenario, and that makes it stand out:
Source: Portfolio Visualizer
If you look closer at the graph you will notice the fund had a maximum loss of only -10% during the stomach churning COVID sell-off in 2020. That is due to its rolling put structure and it makes a massive difference in the way one thinks about this product. Basically the above graph tells us that we should expect to clip about a 7% annual dividend from ETJ with a maximum historical loss of only -10% (on a monthly measurement basis, not daily). So a 1 : 1.4 upside/downside scenario. Think about other high dividend products and look at the maximum loss they exhibited during COVID 19 and you will understand the appeal for ETJ. You will tend to see 40%-60% loses for other instruments with high yields.
Is it a good time to buy now?
The fund spent most of the past decade with a market price below NAV:
Source: CEF Connect
In the above graph the orange line is the NAV and the blue line is the market price. You can see that really only recently did the fund start trading above NAV due to yield requirements from investors hungry after a 0% rates policy from the Fed. With a tightening cycle set to characterize 2022, and a hawkish Fed we are mindful of a reversion to historical patterns, namely for ETJ to trade below NAV. In our mind this is not the best entry point although the fund is very robust on analytics and risk/reward metrics long term. A savvy investor is well served to start slowly layering in and accelerating purchases once the price falls below NAV.
Conclusion
An equities focused CEF, ETJ employs a collar strategy to extract yield from the underlying stocks portfolio and to protect the downside of the fund during sell-off scenarios. With robust long term metrics and trailing total returns, ETJ is a good vehicle to utilize to generate yield from an equities portfolio utilizing options technology. While currently trading at a small premium to NAV, we find ETJ attractive and are Bullish on the name. A savvy investor is well served to start slowly layering in and accelerating purchases once the price falls below NAV.
This article was written by
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.
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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