FFA - ETB And FFA: An Opportunity For A Swap

2024-01-09 16:34:52 ET

Summary

• Both the Eaton Vance Tax-Managed Buy-Write Income Fund and the First Trust Enhanced Equity Income Fund implement an options writing strategy but carry it out in different ways.
• They both deliver respectable distribution yields, with ETB paying monthly and FFA paying quarterly.
• However, the valuation difference between the two makes ETB look much more appealing on both an absolute and relative basis.

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

In mid-2023, I wrote an update that covered both the Eaton Vance Tax-Managed Buy-Write Income Fund ( ETB ) and the First Trust Enhanced Equity Income Fund ( FFA ). At that time, both funds were attractively priced with regard to the discounts that these closed-end funds traded at. In that piece, we also looked at how the funds implemented a similar strategy, but they had some nuances.

In particular, FFA has a bit more flexibility in its approach as ETB takes a relatively more mechanical approach to writing calls against the S&P 500 Index. FFA, on the other hand, can write against indexes or underlying positions of the fund (i.e., write covered calls.) In addition to that flexibility, FFA also takes a more active approach in terms of how overwritten its portfolio is. The last fact sheet available has the fund about 67% overwritten whereas ETB overwrites nearly 100% of its portfolio. Having a higher portion of the portfolio overwritten can be a more defensive approach, as writing calls is a slightly defensive strategy. Premiums can be taken in to offset some losses, but they ultimately work best in a flat market with limited movement one way or another.

Options writing can also end up capping potential upside as well. In the case of writing against indexes, they are cash settled, so they are technically writing naked calls, as an index can't be owned directly. However, they hold securities in their underlying portfolio that will generally be rising if the index is rising and falling if the index is falling.

Since that prior coverage of the two funds, I had covered FFA more recently , which I ended up switching the fund to a 'Hold' rating given the narrow discount on an absolute and relative basis. Today, it looks like FFA remains a hold, and ETB is still a 'Buy' candidate, which opens up a potential swap opportunity.

ETB Basics

• 1-Year Z-score: -1.51.
• Discount: -10.02%.
• Distribution Yield: 8.71%.
• Expense Ratio: 1.12%.
• Leverage: N/A.
• Managed Assets: $417.4 million.
• Structure: Perpetual.

ETB's investment objective is "to provide current income and gains, with a secondary objective of capital appreciation."

To achieve that objective, they'll focus on "a diversified portfolio of common stocks and write call options on one or more U.S. indices on a substantial portion of the value of its common stock portfolio to seek to generate current earnings from the option premium."

FFA Basics

• 1-Year Z-score: -0.17.
• Discount: -4.42%.
• Distribution Yield: 7.02%.
• Expense Ratio: 1.13%.
• Leverage: N/A.
• Managed Assets: $374.6 million.
• Structure: Perpetual.

FFA's objective is to "provide a high level of current income and gains and, to a lesser extent, capital appreciation." It attempts to do this by investing in "a diversified portfolio of equity securities." So, we are looking at a rather simple portfolio. It then utilizes an option strategy "on an ongoing and consistent basis… on a portion of the Fund's Managed Assets."

The Swap Opportunity And Risk

Since that prior coverage where we looked at both of these funds, it is worth noting that FFA has performed significantly better. However, this was a more recent trend in terms of a total NAV return basis. The funds had been moving nearly identically up until the last month or so.

Where we can see the main difference has come from and in a more material manner was the total share price returns. That's ultimately what has pushed this swap opportunity in favor of picking up ETB over FFA at this time.

Besides the ETB's discount currently being the deepest on a relative basis - and even despite the stronger long-term historical results of FFA - ETB has consistently traded at a richer valuation than FFA except for more recently. The depth of the discount for ETB has been quite extreme on a relative basis, and the downfall from a premium certainly made for a more dramatic fall.

One of the reasons for this difference could be that FFA pays a quarterly distribution, whereas ETB pays monthly.

That being said, historically speaking, FFA has been able to outperform ETB by a fairly significant margin. Though once again here, the NAV return performance for these funds had been quite close for a considerable period of time. It was more in the last few years that FFA had been able to start pulling away in a meaningful manner.

That strong performance where the divergence started happening was right after Covid. Naturally, with some flexibility when overwriting the portfolio, FFA managers could take the percentage down and have consistently been under the nearly 100% that ETB targets. That allows for the fund to participate further in the upside as the portfolio isn't producing losses due to the cash-settled index writing or having a position called away and essentially having a ceiling over participation to the upside.

If we zoom in on the 2022 results, where the market was weaker, we can see that ETB's total NAV returns were limited relative to FFA's. ETB was down less than 13% that year, and FFA was down just over 16%. 2018 was another losing year for the broader market and once again showed that ETB did come out on top a bit, with a total NAV return decline of around -6.7% and FFA at a decline of around -9.5%.

The market also recently had another fantastic year, closing out 2023. This, too, saw FFA outperform as the total NAV return came to 20.49% for the year compared to ETB's 17.6%. Both clearly delivered strong results, but reflecting once again, the higher overwrite of ETB's portfolio is going to cap results.

That's where the primary risk comes in for swap trades; these two aren't necessarily the most ideal swap partners. Should FFA continue to perform significantly better, then the spread in terms of the discount between the two might not be enough.

With all that being said, here is another interesting angle to consider for why this swap potentially makes sense. We know that ETB underperforms when the market is in full bull rally mode. What is more important is the pace of the rise, though; ETB writes options with some upside allowed before being called away.

2023 just closed, with the broader market having a significant rally that pushed nearly 25% . Historically speaking, double-digit returns two years in a row are fairly common. What isn't too common is the 20%+ returns in back-to-back years. That means having another smashing year for the market in which ETB would materially underperform is a low probability. Therefore, I'd tend to lean toward ETB and FFA being able to perform nearly identically over the coming year.

Finally, another risk/consideration is that First Trust seems to be dwindling down its closed-end fund business. They are attempting to merge their energy-related funds together into an ETF, and they announced the board's approval for that on October 23, 2023. In addition, on that same date, they announced that another four of their CEFs would be merged into abrdn funds. On November 21, 2023, they also announced the completion of one of their global funds being merged into an ETF. FFA will be one of the only few CEFs that First Trust will still have. At this point, nothing appears to have been announced, but if a conversion into an ETF was announced, it should eliminate the discount pretty quickly.

Conclusion

FFA and ETB are both funds that employ an option writing strategy while investing in an equity portfolio; the greater flexibility for FFA has seemed to translate into better historical results. However, the valuation difference between the two in terms of an absolute and relative discount favors ETB at this time. In addition, I suspect that the performance of these two should be closer in the near term if the market takes a pause in the coming year. Even if the market still performs fairly well in 2024, the results for the two could be similar. When FFA outperforms materially, it's when we start to get those 20%+ S&P 500 years.

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