ETV - EOI: Strong Results From This Covered Call Fund ~8% Distribution Rate

2023-07-26 17:03:30 ET

Summary

• Eaton Vance Enhanced Equity Income Fund had avoided a distribution cut due to its lower distribution rate last year when most EV funds saw cuts.
• EOI's investment objective is to provide current income and capital appreciation through a portfolio of primarily large- and midcap securities and writing against individual positions in the fund.
• Due to the fund's valuation, it looks like a "Hold," but that doesn't mean it couldn't continue delivering solid results going forward for those with a position.

Written by Nick Ackerman, co-produced by Stanford Chemist.

The last time we updated coverage on Eaton Vance Enhanced Equity Income Fund ( EOI ), we noted that it was one of only a couple of equity EV funds that had not cut their distribution. The only other fund to avoid a cut was Eaton Vance Tax-Managed Buy-Write Strategy Fund, which was ultimately merged into Eaton Vance Tax-Managed Buy-Write Opportunities Fund ( ETV ). The simple reason for EOI to avoid a distribution cut was that its distribution rate hadn't become as elevated.

Since then, EOI has been able to hold up better in terms of its discount/premium level. Its sister funds have mostly all been seeing their discounts widen materially. However, we have seen some discount tightening from just how deep the discounts were.

Overall, this makes EOI perhaps a less attractive choice at this time on a relative basis. Its premium has still come down from where it was, even as they had left its distribution intact. However, being a fairly unique fund - as all the EV funds have a bit of a different approach despite the similar names - it could still provide an interesting choice for some investors.

Over the long run, the fund has provided a solid track record, and with the overall market performing well in 2023, this year has also shown solid results for EOI. More recently, participation has started to pick up more broadly in the market, which is another positive. Inflation is cooling with the latest report , and the Fed is anticipated to be near peak rates. This can all bode well for performance going forward to continue performing well.

The Basics

• 1-Year Z-score: -0.65.
• Discount: -0.89%.
• Distribution Yield: 7.94%.
• Expense Ratio: 1.11%.
• Leverage: N/A.
• Managed Assets: $667.9 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 focuses on the S&P 500 and writes single stock-covered calls against its portfolio. Writing against individual positions in the fund sets it apart from most of the other EV funds that write against indexes. The only other EV fund that writes against individual positions is Eaton Vance Enhanced Equity Income Fund II ( EOS ). We've compared both of these funds previously . As a quick reminder, the main difference is that EOI targets the S&P 500, and EOS targets the Russell 1000 Growth.

Performance - Solid Track Record

Historically the fund has provided some solid results to investors over the years. Due to its options strategy, the covered call strategy can generally lag straight equity funds, such as the S&P 500 Index benchmark. However, it can also limit some of the downside moves in times of struggling or sideways markets.

We'll touch on the performance more below when discussing the portfolio, but this is a unique case where EOI outperformed its straight benchmark over the long term.

EOI runs with 69 total holdings as of their last report ; they also target around 50% overwrite for their options. The last stats provided showed they were 46% overwritten at 23 days out, on average, 2.6% out of the money. So while 50% of their portfolio in a bull market can run unfettered, 50% can be somewhat capped. This is the primary culprit for covered call fund underperformance over longer periods of time.

As an actively managed fund, they can close or roll positions to adjust the position and potentially allow for further upside. That said, this can also create losses. This would be why we've seen in the latest semi-annual report that their written options have actually lost money for the fund.

Their last fiscal year annual report showed some positive written options contributions to the fund's results. It was a fairly negligible amount, but it reflects that it isn't a long trend of producing losses from their options strategy.

When it comes to the fund's valuation, it would appear that the fund over the last decade had traded at a discount most of the time. This has resulted in the longer-term average for the fund being at a discount. In the last couple of years, it's been a more recent move where the fund has flipped to start trading at a premium quite regularly.

This is what primarily makes EOI a bit less appealing relative to some of its sister EV funds that are already trading at their longer-term averages or even deeper.

Distribution - Steady

Outside of the fund's cuts around the Global Financial Crisis, the fund has paid a fairly regular distribution. They've even raised a couple of times since those series of cuts.

As the distribution rate on the NAV remains at around 7.97%, it's at a level that could be considered quite reasonable. Due to the fund trading around parity with its NAV, the distribution rate for investors is a very similar 7.94%. This is another downside of a fund trading at parity or a premium to NAV; you don't get any 'enhanced' distribution.

While the fund has a covered call strategy that can potentially contribute to capital gains, it will still require strong equity results. So the results we are seeing this year are vital to the long-term sustainability of the distribution. The net investment income generated in the underlying portfolio is insufficient for coverage, and for this fund is particularly low. However, this is not unusual for equity CEFs; this is standard distribution operating procedure. This is exactly why we saw so many EV funds slash their payouts last year when equities struggled.

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 classified as long-term capital gains, with 2022 reflecting this.

EOI's Portfolio

Part of the tax strategy of the other funds is not realizing gains from their underlying portfolio. This can naturally lead to a fairly limited amount of turnover on some of the EV funds, in general. However, EOI with no tax-managed strategy allows them more flexibility to portfolio turnover. The last six-month report showed a turnover of 27%, with the last five years showing an average turnover of around 45%.

For some context, ETV's average turnover in the last five years was 10.4%. That includes the 19% turnover reported in 2022, which was more than double any of the other prior years.

Despite only 69 holdings for EOI, they do a great job of reflecting nearly identical weightings to the S&P 500 itself. They simply do so with a sampling approach.

Different positioning can also result in different outcomes between it and the S&P 500. These differences would be above and beyond what the covered call strategies cause. This is also along with EOI's expense ratio.

However, sampling can also lead to outperformance if they successfully pick out the select few outperformers. Historically speaking, EOI has been able to deliver this. That's why this is a fairly unique covered call fund that has outperformed its straight vanilla benchmark. EOI has provided superior results over the SPDR S&P 500 ETF ( SPY ).

Doing most of the heavy lifting for these results is the mega-cap growth names referred to as the magnificent 7 these days. It's not a top holding, but NVIDIA ( NVDA ) also makes its way into their portfolio at a 1.89% weighting, putting it in the 11th position, just off the top ten.

Conclusion

Over the long run, EOI has outperformed the S&P 500 benchmark, a fairly rare feat given the covered call strategy during a long bull market. They've accomplished this through portfolio positioning being more selective relative to the broader index.

However, this requires management to continue to be correct going forward. You can also find periods where EOI would underperform depending on the time frame. Case in point, on a YTD basis so far, EOI is slightly lagging behind the S&P 500.

We won't ever know exactly how management will perform going forward, but one thing we can control is when we enter a fund. When a fund trades at a deeper relative discount, we can generally increase our odds of performing well. Due to the lack of discount here, I can only see EOI as a "Hold" at this level, despite its solid track record and attractive distribution rate.

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