EXD - EOI: A Strong Choice For A Covered Call Fund

Summary

• EOI is a bit different than the rest of the Eaton Vance option-writing funds in that it writes on individual positions.
• This is one of the EV equity funds that avoided having its distribution trimmed, but the valuation has come down nonetheless.
• Like most of EV's funds, it is a solid fund - however, I'd be looking for a better entry at a discount.

Written by Nick Ackerman, co-produced by Stanford Chemist. This article was originally published to members of the CEF/ETF Income Laboratory on January 10th, 2023.

Eaton Vance Enhanced Equity Income Fund ( EOI ) avoided the distribution cuts that most of the EV equity funds experienced several months ago. That left it in a rare group as only one other fund hadn't been cut.

EXD was the other fund, but it was later announced they were looking to merge EXD into ETV. Simply put, equities declined sharply, and Eaton Vance adjusted the payouts to more reasonable levels. EOI's distribution rate on NAV wasn't overly elevated, so it avoided the slash. Several of these funds had their distributions boosted toward the end of 2021, so now EOI is the only one of those that has maintained that heightened payout.

That being said, the latest premium had come down anyway. Perhaps this was in sympathy or just a general sell-off for tax-loss harvesting; it is really anyone's guess. Despite that decline, the fund is still left at a small premium, when over the longer term, a discount has been a more regular occurrence.

For investors looking to enter a long-term position, now could represent a fairly attractive time to consider this fund due to equities being in decline overall. Still, a more patient investor could enter a position through a dollar-cost averaging approach.

The Basics

• 1-Year Z-score: -0.39
• Premium: 0.27%
• Distribution Yield: 8.70%
• Expense Ratio: 1.10%
• Leverage: N/A
• Managed Assets: $637.1 million
• Structure: Perpetual

EOI's investment objective is to "provide current income, with a secondary objective of capital appreciation." They attempt to achieve this through "a portfolio of primarily large- and midcap securities that the investment adviser believes have above-average growth and financial strength and writes call options on individual securities to generate current earnings from the option premium." EOI targets around 50% of its portfolio being overwritten at any time.

While on the surface, it might appear like most other Eaton Vance equity funds, as usual, it has a bit of a nuance that sets it apart. In this case, EOI writes covered calls, which means writing options on individual positions. The only other EV option writing fund to do that is EOS.

We discussed this in the past on these two funds , specifically what sets them apart, too. The main difference here is that EOS targets the Russell 1000 Growth Index, and EOI targets the S&P 500 Index.

This should be a relatively more conservative fund with an options writing strategy and no leverage. It could be a place to look for investors who might be loaded up too heavily on leveraged funds for the current environment.

Performance - Slight Premium But Equities Are Lower

Part of the fund's strong historical performance is due to the bull market in most of the last decade. That can also be its downfall, as option writing funds tend to lag in a rapidly rising market. This happens because positions get called away that would otherwise rise, or they can close out option positions at a loss to not have the stock called away.

Still, on an annualized basis, the fund has put up quite competitive results. Note that this is through the end of September 30, 2022. That's their fiscal year-end and, subsequently, their last available annual report .

Of course, 2022 sent that the other way with large losses. Losses that we haven't seen since 2008. On a total NAV return basis, EOI declined by 17.35% compared to the S&P 500 Index's ~19.4% decline for 2022.

Positioning of the fund certainly plays a role in the different outcomes as they carry only 67 stocks. However, the options writing that the fund implemented also provided a positive boost for the fund.

Albeit, quite a bit smaller, relatively speaking, than we saw for other covered call writing funds. They ended up collecting $757k in realized gains for their fiscal year. They also showed $616k in unrealized gains due specifically to their written options. This can happen if some of the positions their writing against do well, well enough, where they feel that closing out the position at a potential loss can make more sense.

That's why covered call writing funds can be a great choice in a flat or slightly declining market. They collect premiums when there could otherwise be no or limited gains from the underlying portfolio.

Unfortunately, investors have bid up this fund in more recent years to some high premiums. The premium has come down more lately, but it still remains above the longer-term average. There is a trend of a narrowing discount until these premiums have been touched. I'm not so sure that trend can continue, though, now that we are brushing into premiums.

That's why overall, I'd be a bit more cautious with adding aggressively here. The silver lining is that equities are down as a whole quite significantly in the last year too.

Distribution - No Cut, 8.70% Rate

The latest monthly $0.1095 distribution and premium puts the distribution yield at 8.70%. There is only a minimal difference between the share price and NAV rates; the NAV distribution rate is virtually identical at 8.72%.

They are susceptible to distribution cuts just as any other equity fund is, but they haven't done so since closer to the GFC and the following years.

The largest source of covering their distribution comes from realized capital gains. That can come from the underlying portfolio or from the options premium, as we highlighted above. NII coverage in this fund is quite low. It comes in at just around 5.5%. Year-over-year, there was almost no material change in this level.

We can see that in both years, realized capital gains came in to cover the payout. That's despite the 2022 fiscal year showing significant unrealized capital losses, too. That's not something we should ignore. With equity funds, it is expected in down years, particularly when we have down years as bad as 2022.

With many years of previous appreciation, they have a sizeable amount of embedded gains from which they can generate these long-term gains. At the end of their fiscal year, they reached almost $161 million in net unrealized appreciation in their portfolio. Also, just because most prices were falling, that doesn't mean everything in their portfolio was.

Another difference you might notice with EOI is when it comes to tax time. While many EV option-based funds have a tax-advantaged focus, EOI doesn't have that specific focus. Therefore, they aren't looking to generate significant amounts of return of capital to defer tax obligations. In this case, most distributions have been long-term capital gains in the prior two years.

EOI's Portfolio

As mentioned above, they carry 67 positions in their portfolio when they track the S&P 500 - which carries just over 500 tickers. That means they're doing much of the same with a significantly more narrow portfolio. That includes closely mirroring the sector exposure to the S&P 500 Index .

Although 67 positions is probably a lot for individual investors, for a fund, it isn't overly aggressive. To mirror the S&P 500 Index, the fund will invest in many of the same names with the highest exposure - EOI then ramps up the exposure to each position even further to fill out their portfolio. The top ten for the fund make up 36.75% of the invested capital. For the S&P 500, as of writing, the top ten made up 23.79%.

That means it is little surprise that we see many overlap names within EOI and the S&P 500 Index. We have Apple ( AAPL ), Microsoft ( MSFT ), Alphabet ( GOOG ) (although no ( GOOGL ) for EOI,) Amazon ( AMZN ) and UnitedHealth Group ( UNH ) that are represented in both this fund and the index.

That does leave a little room for flavor and discrepancy as EOI includes: PepsiCo ( PEP ), Mastercard ( MA ), Eli Lilly ( LLY ), Procter & Gamble ( PG ) and Wells Fargo ( WFC ). Although these are all names within the S&P 500 Index, they come in at smaller weightings. Of these, WFC represents the largest position for EOI but the smallest weighting of these names in the index (i.e., WFC is materially overweight in EOI relative to the benchmark.)

Instead, the S&P 500 favors JPMorgan ( JPM ) as its top financial holding. EOI was on the winning side of that bet for most of the last year until the more recent performance. Although, neither put up any positive performance in the last year, so there is no room for bragging.

Conclusion

EOI is a solid fund for long-term investors. An added benefit here is that as a closed-end fund with an options focus and no leverage, this type of fund could do well in the current environment if one expects limited gains in the overall market from here. Although the fund is trading at a slight premium, the overall market has declined significantly in the last year. That could be presenting a fairly opportune time to consider this fund. However, a more patient investor could wait for a discount to appear or approach it with a dollar-cost averaging strategy, nibbling in through smaller positions over time.

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