ETJ - ETJ: Good Way To Invest In Equities With Reduced Risk

2023-12-02 04:59:25 ET

Summary

• ETJ is an equity closed-end fund that invests in a portfolio of common stocks and hedges its exposure using both put and call options.
• The fund pays monthly distributions using a managed distribution plan and aims to maximize after-tax total return.
• ETJ is currently selling at a 4.89% discount to NAV and has a fairly high distribution rate of 8.72%.

Eaton Vance Risk-Managed Diversified Equity Income Fund ( ETJ ) is an equity closed-end fund that invests in a diversified portfolio of common stocks and hedges its exposure by:

• Buying out-of-the-money short-dated S&P 500 index put options.
• Selling out-of-the-money S&P 500 index call options of the same term as the put options.
• The option roll dates are staggered across the options portfolio

The Fund pays monthly distributions using a managed distribution plan. The fund managers try to maximize after-tax total return by seeking to minimize and defer federal income taxes.

(Data below is sourced from the Eaton Vance website unless otherwise stated.)

The fund is currently selling at a 4.89% discount to NAV, which is about average for the last year.

Here is a five-year history of the ETJ premium/discount from CEFConnect:

ETJ Eaton Vance Risk-Mgd Divers Eq Inc, closed-end fund summary - CEF Connect - Brought to you by Nuveen Closed-End Funds

The Fund invests primarily in large cap stocks with a small allocation to mid caps. The top holdings are highly correlated with the S&P 500, which makes the S&P 500 option hedging more effective. Here are the top ten holdings as of October 31, 2023:

Sector Breakdown

Source: ETJ Fact Sheet, September 2023

Within the equity covered call CEF sector, I prefer funds that use index options over those that use options on individual stocks. Aside from the tax advantage, the options on stock indexes generally trade with a lower bid-asked spread and are much more liquid. This means reduced "slippage" costs, resulting in less drag on performance. ETJ only uses options on the S&P 500 that are highly liquid.

Below is a summary of the put and call options used by the Fund. On average, the long put options are only slightly out of the money. The call options written are generally about 5% out of the money. Note that 96% of the portfolio is hedged, which means that ETJ has reduced downside risk. But in return for this, you give up some of the upside returns.

Source: ETJ Fact Sheet, September 2023

Let's do a deep dive and take a look at some of the option hedge trades from the last semi-annual report. The Fund does option trading nearly every day, but I've chosen options that expire on three days - July 5, 6 and 7.

The option holdings in the S&P 500 Index contract were:

Source: ETJ Semi-Annual Shareholder Report

Note that the fund managers were not trying to time the market. They execute balanced option exposure trades each day with long puts slightly out of the money and short calls about 5% out of the money.

Distributions

As with many covered call funds, the fund uses a managed distribution plan where they currently pay $0.0579 per month. The monthly distribution has remained unchanged since October 2022, when it was reduced from $0.076.

Generally, most of the distributions are capital gains or return of capital, which is intentional since the fund tries to maximize after-tax total return. For example, this was the tax breakdown in 2022:

Capital Gains Distributions: $0.55

Return of Capital: $0.29

Qualified Ordinary Div: $0.03

Total Distributions= $0.87

Risk-Managed Diversified Equity Income Fund

Given the high annual distribution rate, you might expect the NAV of ETJ to gradually fall over time. But by re-investing the distributions (either back into ETJ or into other investments), you can still get a decent after-tax total return.

That said, I think ETJ can be a good short-term swing trading stock to be owned when you want to get more defensive. I don't see it as a long term buy and hold fund that you put away and forget about.

Here is the total return NAV and price performance record of ETJ since 2013 compared to Morningstar's Moderate Risk category. Note how ETJ generally outperforms the S&P 500 in bear market years, but underperforms in bull market years because of its option hedging activities.

Source: Morningstar EV Risk-Mgd Divers Equity Inc ETJ

ETJ Fund Management

1) Charles Gaffney, Managing Director, Portfolio Manager

Charlie is a managing director of Morgan Stanley and a portfolio manager on the Eaton Vance Core/Growth team. He is responsible for buy and sell decisions, portfolio construction and risk management for a number of Eaton Vance U.S. core equity strategies. He is a member of the Eaton Vance Equity Strategy Committee. He is also a vice president and portfolio manager for Calvert Research and Management. He joined Eaton Vance in 2003. Morgan Stanley acquired Eaton Vance in March 2021.

Charlie began his career in the investment management industry in 1996. Before joining Eaton Vance, he was a sector portfolio manager with Brown Brothers Harriman and a senior equity analyst with Morgan Stanley Dean Witter.

Charlie earned a B.A. from Bowdoin College and an MBA from Fordham University.

2) Douglas R. Rogers, CFA, CMT, Executive Director, Portfolio Manager

Doug is an executive director of Morgan Stanley and a portfolio manager on the Eaton Vance Core/Growth team. He is responsible for buy and sell decisions, portfolio construction and risk management for Eaton Vance growth equity strategies. In addition, he covers the information technology and communication services sectors. He joined Eaton Vance in 2001. Morgan Stanley acquired Eaton Vance in March 2021.

Doug served as a nuclear submarine officer in the United States Navy prior to beginning his career in the investment management industry in 1999. Before joining Eaton Vance, he was a research analyst with Endeca Technologies Inc.

Doug earned a B.S. from the United States Naval Academy and an MBA from Harvard Business School. He holds the Chartered Market Technician (CMT®) designation and is a CFA charterholder.

Source: ETJ Web Site

Discount History

The discount to NAV as of November 30 is -4.89%. The one-year discount Z-score is +0.09 and the one-year average discount is -5.04%, which means that the current discount to NAV roughly in line with the average discount over the last year.

Source: CEFConnect

Alpha is Generated by Discount + High Distributions

The high distribution rate of 8.72% along with the 4.89% discount allows investors to capture a little bit of alpha by recovering a portion of the discount whenever a monthly distribution is paid out.

Whenever you recover NAV from a fund selling at a 4.89% discount, the percentage return is 1.00/0.9511 or about 5.14%. So the alpha generated by the 8.72% distribution is computed as:

(0.0872)*(0.0514)=0.0045 or about 0.45% a year in discount capture alpha.

Note that this almost half of the 1.12% baseline expense ratio.

Here is a chart showing year-to-date return for ETJ. Note the reset at the beginning of 2023.

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Ticker: ETJ Eaton Vance Risk Managed Diversified Equity Fund pays monthly

• Total Assets= $564 Million
• Annual Distribution (Market) Rate= 8.72%
• Fund Expense ratio= 1.12%
• Discount to NAV= -4.89%
• Portfolio Turnover rate= 55%
• Average Daily Volume= 158,000
• Average Dollar Volume= $1.25 million
• Call Options (written) as a % of total assets= 96%
• Put Options (owned) as a % of total assets=96%
• No leverage used

Because of the recent run-up in the stock market, this may be a good time to consider adding some ETJ in your portfolio as a partial hedge. It is fairly liquid and easy to purchase. Because of its tax management policy, it can be a good holding in either a taxable account or an IRA. I would try to buy ETJ at a discount of 7% or higher, and would consider trimming some shares if it trades at a premium again, like it did in 2021 and 2022.

Full Disclosure: Long ETJ.

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