IVV - EOS: Earn Some Income With This Overwrite CEF

2023-07-25 16:51:51 ET

Summary

• Investors today are in desperate need of income due to the rapidly rising cost of living in the United States and elsewhere.
• Eaton Vance Enhanced Equity Income Fund II invests in a portfolio of mostly American stocks and then writes covered calls against them in order to earn premium income.
• The EOS closed-end fund is very heavily invested in the technology sector, so it is necessary to add other sectors to your portfolio in order to achieve proper diversification.
• The fund failed to cover its distribution last year and we will have to wait for an updated financial report to see if it can cover the new one.
• The fund is trading at a discount to the net asset value.

There can be little doubt that one of the biggest problems facing the average American today is the incredibly high inflation rate that has been dominating the U.S. economy over the past two years or so. This inflation is pushing up the price of everything we regularly buy or consume and making it much more expensive to maintain the same lifestyle that we had only a year or two ago. The extent of this problem is immediately apparent by looking at the consumer price index, which claims to measure the price of a basket of goods that is regularly purchased by the average American consumer. As we can see here, this index has been increasing at more than the 2% annual rate that the Federal Reserve's economists consider to be healthy. In fact, the index has posted a year-over-year increase that is well above this level during each of the past twelve months:

Inflation is still a problem despite the fact that the annual growth rate appears to be slowing down. First, inflation compounds just like the investments in your portfolio. As such, the fact that the 3% year-over-year increase that we saw in the most recent month came on the heels of a 9.1% year-over-year increase in the prior year period, resulting in a very substantial increase for consumers over a two-year period. In addition, the inflation rate is currently artificially low due to the fact that energy prices are lower this year than they were last year. If we exclude energy prices, the year-over-year inflation numbers look much worse than the chart above shows.

I have discussed this in various previous articles. Due to a combination of these two factors, the average person is having a much more difficult time dealing with the rising price level than the news headlines and analyst reports might suggest. This situation has even forced some people to begin pawning possessions and dumpster diving for food . In short, people are getting very pinched financially and are increasingly desperate for additional sources of money just to make ends meet.

As investors, we are certainly not immune to this. After all, we require food and need money to pay our heating and electric bills just like anyone else. Fortunately, we have ways to obtain the extra money that we need for this purpose that do not require resorting to some of the extreme measures that were just mentioned. For example, we can put our money to work for us to earn the extra income that we require in today's environment.

One of the best ways to do this is to purchase shares of a closed-end fund aka CEF that specializes in the generation of income. These funds are unfortunately not very well followed in the financial media, and many investment advisors are unfamiliar with them. As such, it can be difficult to obtain the money that we would really like to have to make an informed investment decision. This is a shame because closed-end funds offer a number of advantages over ordinary open-ended or exchange-traded funds. In particular, a closed-end fund has the ability to employ certain strategies that can boost their effective yields well beyond that of any of the underlying assets or indeed pretty much anything else in the market.

In this article, we will discuss the Eaton Vance Enhanced Equity Income Fund II ( EOS ), which is one CEF that can be used to earn an income. This is immediately apparent in the fact that this fund boasts a 7.63% yield at the current price. I have discussed this fund before, but several months have passed since that time so obviously a great many things have changed. This article will therefore focus specifically on these changes as well as provide an updated analysis of the fund's finances. Therefore, let us investigate and see if this fund could make sense for your portfolio today.

About The Fund

According to the fund's webpage , the Eaton Vance Enhanced Equity Income Fund II has the objective of providing its investors with a high level of current income. This is a somewhat surprising objective for a fund whose name implies that it invests in common equities. The fund is as good as its name too, as it does indeed invest entirely in common equity. As we can see here, the fund is fully invested in a combination of American and foreign common stock, although it is does have a short cash position:

The reason why the fund's objective is unusual in this light is that common equity is not generally considered to be an income vehicle. After all, the S&P 500 Index (SP500) only yields 1.44% at its present level. This means that a $1 million portfolio will produce $14,400 in annual income. That is not exactly an attractive level of income for anyone that managed to accumulate a portfolio of that size over their lifetime. In fact, it is nearly impossible to get an attractive dividend yield from any American stock outside of the fossil fuel sector. Eaton Vance funds are not known for investing heavily in that sector, so this means that the fund must be doing something else to produce income from a common stock portfolio.

The key here comes from the fact that this is a self-described "enhanced" equity income fund. The word "enhanced" in the name of any closed-end fund means that it will be using some sort of options strategy to generate income beyond what its common stock portfolio is able to accomplish. In this case, that options strategy is a covered call writing strategy. The fund's fact sheet describes its strategy:

The fund invests in a portfolio of primarily large- and midcap securities that the investment advisor believes have above-average growth and financial strength and writes call options on individual securities to generate current earnings from the option premium.

The fact that the fund is using an options strategy might be concerning to some investors, particularly those that have a low risk tolerance. After all, we have all heard the horror stories about people losing large amounts of money through the use of options. However, the covered call strategy is a fairly safe one, all things considered. This is because the fund already owns the stock that it would have to sell in a worst-case scenario. The biggest risk with writing call options is that you have to deliver the stock if the option is exercised against you by the buyer. If you do not own the stock, then you have to go out into the market and buy it, potentially paying any price to obtain it and then selling at a loss. After all, nobody will exercise a call option unless the market price of the stock is well above the current selling price. As the fund already owns the stock corresponding to the option, the worst scenario is that it will have to sell the stock that it already owns.

This is a strategy that is largely devoid of risk, as the worst situation is that you have to sell the stock for cheaper than you would without writing the option. This is the reason why covered call writing funds tend to underperform in raging bull markets, as they are not able to capture all of the upside potential from their stock positions. The benefit comes in the fact that the fund receives an upfront payment from the option buyer that serves as income and helps to offset losses in a bear market. Due to these collected premiums, covered call funds tend to outperform in flat or bear markets.

We can actually see this performance profile by looking at the fund's total returns. As of June 30, 2023, the Eaton Vance Enhanced Equity Income Fund II delivered a 23.14% total return year-to-date. Here are the fund's full performance numbers for each of the trailing periods ending on that date:

(Data from Eaton Vance as of June 30, 2023)

It is important to note that the above chart provides the total return data, which assumes that the investor used the fund's distributions to purchase more shares of the fund. Admittedly, many investors in income-focused funds like this one will not actually do that so their total returns will end up being lower. That is particularly true over longer periods of time.

Here are the returns for the iShares Core S&P 500 ETF ( IVV ), which should be able to serve as a proxy for the S&P 500 (SP500):

As we can see, with the exception of the trailing one-year period, the S&P 500 Index generally beat the Eaton Vance Enhanced Equity Income Fund II. This fits in well with my statement that the Eaton Vance fund should underperform in bull markets but outperform in a bear market. The only period of time in the chart above during which the S&P 500 Index exhibited any significant weakness is the trailing one-year period. It was incredibly strong during all of the other periods, driven by the unprecedented money creation in the United States and most other developed nations. The Eaton Vance fund does consistently have a much higher yield than the index though, so it may still prove attractive for someone that wants a modicum of stability and a high distribution yield that provides income.

As I have pointed out in numerous past articles, including the last one on this fund, Eaton Vance's funds have a tendency to be highly exposed to only a few mega-cap technology companies. This one is certainly no exception to that. Here are the largest positions in the fund:

The fact sheet states that 38.27% of the fund's assets are invested in the technology industry, but the fact sheet is dated March 31, 2023 so it is a bit older than the chart above. Still, we can see that the fund is heavily exposed to technology as just the technology companies in the chart above account for fully 45.25% of the fund's holdings. It seems quite probable that the fund has some companies that are not among its largest positions so its total exposure to the sector is probably even higher. That is, to put it mildly, substantially above the S&P 500 Index's 28.27% weighting to technology.

Thus, in some ways, this can almost be considered a technology fund. That would ordinarily seem very strange for an equity income fund, but in this case it does make a certain amount of sense because of the options strategy. As I discussed in a recent blog post , pretty much the entire return of the S&P 500 Index year-to-date has been due to seven technology stocks. The rest of the index has been surprisingly flat, although it has started to creep up in the past few weeks. This has made these stocks much more profitable than the rest of the market when it comes to earning options premiums. I pointed this out in a previous article .

With this portfolio, it appears that the fund is trying to maximize the potential income that it can get through the call writing strategy. This overall makes a lot of sense, but it is very important to keep the outsized exposure to the technology sector here and ensure that the rest of your portfolio is configured in a way to achieve proper diversification across sectors.

The largest positions in the fund are much the same as the last time that we discussed it, although the weightings have changed considerably. This could be caused by one stock outperforming another in the market and is not necessarily a sign of the fund conducting trading activity. The only two major changes to the largest positions list over the past six months are that Texas Instruments ( TXN ) and Coca-Cola ( KO ) were both removed and replaced with Nvidia Corporation ( NVDA ) and Lam Research ( LRCX ). This could point to the fund having a relatively low annual turnover. That is, in fact, the case as the fund had a 15% annual turnover in 2022. This is incredibly low for an equity closed-end fund. It is also very low for this fund, as the Eaton Vance Enhanced Equity Income Fund II usually has higher portfolio turnover:

(figures from 2022 annual report.)

The reason that this is important is that it costs money to trade stocks or other assets, which is directly billed to the fund's shareholders. This creates a drag on the fund's portfolio and makes management's job more difficult. After all, the fund's managers need to earn sufficient returns to cover the trading expenses and other fees, and still have enough left over to provide a reasonable return to the shareholders. That is a very difficult task that very few management teams are able to accomplish on a consistent basis. This is one reason why actively-managed funds tend to underperform their benchmark indices. As we saw earlier, this fund has historically underperformed during bull markets but has outperformed during flat or bear markets.

Distribution Analysis

As mentioned earlier in this article, the primary objective of the Eaton Vance Enhanced Equity Income Fund II is to provide a high level of current income for its investors. In order to achieve this goal, it assembles a portfolio of common stocks and then writes call options against these stocks in an attempt to collect the premiums without having the option exercised against it. If done correctly, this can result in very high synthetic yields from the stocks in the underlying portfolio. The fund then pays out this money in the form of distributions to its investors.

As such, we can expect that the fund will have a fairly high distribution yield. That is indeed the case, as the fund currently pays a monthly distribution of $0.1152 per share ($1.3824 per share annually), which gives the fund a 7.63% yield at the current price. The fund's distribution has varied a bit over the years, but it did generally increase over the 2012 to 2022 period. The fund cut it in November of last year though, which was probably due to the very disappointing performance that major technology stocks delivered during that year.

The fact that the fund's distribution has varied a bit, and especially the cut late last year may reduce its appeal in the eyes of those investors that are seeking a safe and secure source of income to use to pay their bills or finance their expenses. However, it is important to keep in mind that anyone buying the fund today will receive the current distribution at the current yield and will not actually be injured by the fund's past performance. As such, the most important thing for our purposes today is the fund's ability to sustain its current distribution. Let us investigate this.

Unfortunately, we do not have an especially recent document that we can consult for the purposes of our analysis. As of the time of writing, the fund's most recent financial report corresponds to the full-year period that ended on December 31, 2022. As such, it will not contain any information about the fund's financial performance so far this year. That is a shame, as the technology sector has outperformed year-to-date so the fund's performance over the past six months was probably better than this report indicates. With that said though, this report is newer than what we had the last time that we discussed the fund and it will give us a good idea of how it performed during the 2022 period that was generally very challenging for most funds other than those in the energy sector.

During the full-year period, the Eaton Vance Enhanced Equity Income Fund II received $9,201,155 in dividends and surprisingly nothing in interest. As such, the dividend income comprised the fund's entire net investment income. It paid its expenses out of this amount, which left it with a net investment loss of $1,043,183 during the period.

Obviously, that was not enough to pay any distributions, but the fund still paid out $82,705,383 to the investors. This is likely to be concerning at first glance, since the fund's net investment income did not come anywhere close to covering its distributions.

However, the fund does have other methods through which it can obtain the money that it needs to cover the distribution. For example, it might have had some capital gains that can be paid out. The fund will also have premium income from the options strategy, which will be considered either return of capital or capital gains depending on the situation. As might be expected from the challenging conditions in 2022, though, the fund failed miserably at this task.

During the full-year period, the fund had net realized gains of $55,804,003 but this was more than offset by $382,397,093 of net unrealized losses. Overall, the fund's net assets declined by $391,881,943 over the full-year period after accounting for all inflows and outflows. In other words, this fund did not come anywhere close to covering its distributions. This certainly explains the distribution cut. It remains to be seen whether or not the fund's new lower distribution is sustainable or not. This is something that we will want to examine once the fund releases an updated financial statement.

Valuation

It is always critical that we do not overpay for any assets in our portfolios. This is because overpaying for any asset is a surefire way to earn a suboptimal return on that asset. In the case of a closed-end fund like the Eaton Vance Enhanced Equity Income Fund II, the usual way to value it is by looking at the fund's net asset value. The net asset value of a fund is the total current market value of all of the fund's assets minus any outstanding debt. It is, therefore, the amount that the shareholders would receive if the fund were immediately shut down and liquidated.

Ideally, we want to buy shares of a fund when we can obtain them at a price that is less than the net asset value. This is because such a scenario implies that we are purchasing a fund's assets for less than they are actually worth. This is, fortunately, the case with this fund today. As of July 24, 2023 (the most recent date for which data is available as of the time of writing), the Eaton Vance Enhanced Equity Income Fund II had a net asset value of $18.79 per share but the shares currently trade for $18.21 each.

This gives the fund's shares a 3.09% discount to the net asset value at the current price. This is not quite as good as the 3.87% discount that the shares have averaged over the past month, but it is reasonably close. The current price is probably an acceptable price to pay for the fund, all things considered.

Conclusion

In conclusion, the Eaton Vance Enhanced Equity Income Fund II is a reasonable way to earn an income and still retain some exposure to the stock market. However, the fund's performance will be somewhat weaker than the market during bull periods. The biggest problem here though is that the fund is very heavily exposed to the technology sector, so you will need to take this into account when constructing your overall portfolio and increase your weightings to other sectors to achieve appropriate diversification. It is also uncertain how sustainable the distribution is at the new level, but the strong performance of technology so far this year should help for the time being. Overall, this fund might be worth considering for income as long as you take appropriate steps to achieve diversification.

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