EOS - EOS: Opportunistic Entry Point For Risk-On Equity And Income Fund

2023-04-07 08:46:30 ET

Summary

• EOS dipped below a 5% discount to NAV at the end of March 2022: the most significant discount since COVID hammered the markets in 2020.
• Although the team at Eaton Vance had an uncharacteristically bad 2022, EOS is still a best-in-class performer among actively managed equity CEFs.
• Now is an excellent opportunity for interested long-term investors to initiate or add to a position in EOS if they can stomach the possibility of continued short-term underperformance in tech.

One unique quirk of closed-end funds ((CEF)) is how their pricing is market-driven instead of being determined by an index or end-of-day net asset value ((NAV)). If you want to learn more about how CEF pricing can influence investment decisions, Fidelity has a great article on the topic . This creates unique opportunities for eagle-eyed individuals to buy at discounts to NAV or sell at premiums to NAV to optimize the performance of their investments.

The Eaton Vance Enhanced Equity Income Fund II ( EOS ) presents one such buying opportunity as the fund has been trading at an atypically high discount to NAV since the end of March 2023. Although this price discrepancy was most likely inspired by poor 2022 performance, the market has overreacted. Today, long-term investors can buy shares of a best-in-class CEF on sale provided they understand the Fund's counterintuitive risk profile.

EOS Overview

Fund information as of 4/5/2023

• Fund inception: 1/31/2005
• Assets under management: $842.3M
• Leverage: None
• Expense Ratio: 1.09%
• Distribution Yield: 8.58%
• Distribution Frequency: Monthly
• Distribution Amount: $0.1152

EOS is a closed-end fund managed by Eaton Vance, one of the biggest and most experienced firms in the CEF space. The Fund's primary goal is to provide current income with a secondary goal of capital growth. EOS invests in an actively managed equity portfolio of mid and large-cap common stocks and sells covered calls on its underlying equity positions to pursue these goals. Equity portfolio performance is benchmarked against the Russell 1000 Growth Index, and options portfolio performance is benchmarked against the Cboe S&P 500 BuyWrite Index and Cboe Nasdaq-100 BuyWrite Index.

EOS' strategy invests at least 80% of total assets in common stock, at least 75% of which are US domestic equities. Staying true to its name, 99.75% of net assets were invested in stocks as of January 31, 2023, with 96.12% of that allocation invested in US domestic equities. Although call options are written against a "significant" portion of the equity portfolio to generate income, this allocation is never specified. The trend from fund literature suggests that call options are generally written against approximately 50% of the stock portfolio at any given time.

Distributions from EOS are made up of income, short-term gains, long-term gains, and return of capital. Most distributions are taxable in some form, so the fund is best suited for a tax-advantaged account. Please consult your financial advisor or tax professional to determine which investment account is best to hold EOS in light of your financial goals.

Highly Cyclical Growth Portfolio

As of February 28, 2023 , the top 10 fund holdings of a portfolio of 59 equities were as follows:

EOS Top 10 Fund Holdings as % of Net Assets (iShares Russell 1000 Growth ETF ( IWF ) shown for benchmark comparison)

As of December 2022, the top 5 sector allocations were as follows:

EOS Top 5 Sector Allocations as % of Net Assets

EOS has concentrated exposure in some of the largest tech companies, with Coca-Cola ( KO ) being the only non-cyclical ticker on the list. With many of the tech titans being reclassified under the Global Industry Classification Standards (GICS) in the past few years, IT exposure has become more concentrated in the remaining names: most notably Apple and Microsoft. The Vanguard Information Technology Index Fund ( VGT ) offers a good glimpse of what "tech" is now, and many will be surprised to see most of FAANG (or MATANA) is no longer there. Regardless of sector syntax, the Fund's equity portfolio is positioned aggressively, with a greater than 75% allocation to cyclical sectors.

Unlike covered call ETFs, such as The Global X Nasdaq 100 Covered Call ETF ( QYLD ), popular among income investors here on Seeking Alpha, EOS writes covered call options on specific equity holdings. Writing covered calls generally limits the potential capital appreciation of an investment in exchange for receiving a premium when the contract is sold. The management determines which holdings to write call options for, their strike prices, and the number of contracts to sell based on their long-term investment outlook and predictions regarding the short-term performance of portfolio holdings. In my previous article on the fund , I discuss how this strategy functions in EOS' portfolio in more depth. This selection process is opaque to investors, but combining these single ticker short calls and aggressive growth stocks has resulted in very interesting trends in EOS' total return.

Leading long-term performance but short-term trouble

EOS' long-term performance has been impressive, outperforming its benchmark equity index and the S&P 500 through 2021 despite the options overlay that can subdue potential returns.

5Y Total Return of S&P 500, NASDAQ-100, Russell 1000, and EOS

10Y Total Return of S&P 500, NASDAQ-100, Russell 1000, and EOS

The Fund's short-term performance has been different, as 2022 was a disaster for EOS. Referring to the chart below, EOS can be seen following the NASDAQ closely for most of the year before clocking in a 14-month performance with approximately twice the amount of losses as its equity benchmark.

1Y Total Return of S&P 500, NASDAQ-100, Russell 1000, and EOS

This poor showing may have been the impetus for the management's recent decision to lower the dividend from $0.1373 to $0.1152, as four of the last six distributions paid in 2022 relied heavily on return of capital ((ROC)) to meet its distribution obligations. While ROC distributions alone are not necessarily a sign of trouble, the continued use of ROC can imply that the Fund is not generating enough return to pay its shareholders under its current distribution plan. Given the likelihood of more tech headwinds and interest rate pressure on growth equity returns, lowering the distribution to a more manageable level was prudent to maintain the fund's health.

EOS Distribution History Since Inception

The most curious aspect of EOS is the seeming lack of downside protection, even though covered calls are written against half of the portfolio. We can see in the chart below as well that the Fund's overweight tech allocation makes it track the NASDAQ-100 rather than its benchmark. The drawdowns, in particular, tend to exceed those of the Russell 1000 and S&P 500 indexes.

Since Inception % Off High of S&P 500, NASDAQ-100, Russell 1000, and EOS

EOS' volatility also stands out compared to its benchmark and other major indexes, sometimes exceeding the notoriously volatile NASDAQ-100. While the Fund's sector allocations explain some of this behavior, EOS' comparatively high volatility also stems from its small portfolio of approximately 60 positions versus the much larger indexes.

10Y 30-Day Rolling Volatility of S&P 500 ETF, NASDAQ-100 ETF, Russell 1000 ETF, and EOS

Based on its name, investors might think EOS is an equity fund with an options overlay for income and stability similar to the JPMorgan Nasdaq Equity Premium Income Fund ( JEPQ ). In reality, EOS provides investors with top-tier, actively-managed growth equity performance but should not be utilized for defensive equity exposure.

Tech underperformance creates a buying opportunity

Pricing information as of 4/5/2023

• Current Price: $16.12
• NAV: $16.96
• Discount: -4.95%
• 1Y Z-Score: -2.41

EOS' discount to NAV dropped below -5% at the end of March 2023. The last time EOS hit a -5% discount to NAV was at the beginning of the COVID lockdowns in 2020, and the Fund has traded at a premium to NAV for most of the time since then, even throughout its poor performance in 2022. Although investors should not base CEF purchasing decisions on a fund's absolute premium or discount to NAV, pricing for EOS now is both low in absolute terms and in relative terms, as shown by the z-score (see the aforementioned Fidelity article if you are unsure of what a z-score is).

Just because EOS is relatively inexpensive does not mean it will perform well immediately. Current market conditions hint at more pain for the tech and consumer discretionary sectors, and the Fund's aggressive allocations could mean more underperformance in the short term. However, I am optimistic regarding the long-term performance of EOS after we bounce back from this temporary economic instability.

To help illustrate the point, I have created a series of graphs below showing the three-year performance of EOS at multiple -5% discount, -2% discount, and -3 z-score entry points (and two graphs showing entry points at significantly high premiums).

-5% Discount to NAV Entry Points

3Y Performance vs Russell 1000 from 4/27/2017 (-5.15% Discount)

3Y Performance vs Russell 1000 from 12/27/2018 (-5.59% Discount)

-2% Discount to NAV Entry Points

3Y Performance vs Russell 1000 from 7/27/2017 (-2.22% Discount)

3Y Performance vs Russell 1000 from 2/27/2018 (-2.24% Discount)

To-date Performance vs Russell 1000 from 4/28/2020 (-1.97% Discount)

1Y Z-Score ? -3

3Y Performance vs Russell 1000 from 7/27/2007 (Z-Score = -2.94)

3Y Performance vs Russell 1000 from 8/26/2015 (Z-Score = -3.82)

3Y Performance vs Russell 1000 from 2/28/2020 (Z-Score = -3.40)

What happens if you buy at a premium?

+10% Premium to NAV December 17, 2009

+5.28% premium to NAV 5/29/2018

Conclusion

EOS tumbled with the NASDAQ through 2022, but I am confident that 2022 was just an uncharacteristic stumble by the team at Eaton Vance. The Fund has a long track record of superior performance among its CEF peers, and investors looking for long-term growth exposure willing to take a chance on EOS at its low could stand to reap the rewards.

As this was a time-sensitive opportunity, I moved this article ahead of my planned QYLD coverage. Rest assured, the QYLD revisit and QYLD vs JEPQ comparison are still on my to-do list, so please follow me if you want to be notified when those articles are published. If you have any insights, questions, or suggestions for future coverage, please let me and the rest of the Seeking Alpha community know by leaving a comment. Thank you for reading!

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