ETY - ETY: Call Writing Equity Fund Providing Monthly Distributions

2023-12-20 06:04:30 ET

Summary

• Eaton Vance Tax-Managed Diversified Equity Income Fund focuses on a relatively concentrated portfolio of S&P 500 Index names and utilizes a call-writing strategy to provide regular monthly distributions.
• ETY has delivered respectable results and has a historical track record of performing well and delivering distributions to investors.
• The discount on ETY's shares has widened, making it a tempting option for investors over the long term, but we'd ideally want to see an even deeper discount.

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

Eaton Vance Tax-Managed Diversified Equity Income Fund (ETY) provides investors with a basket of equity investments. The fund focuses on the S&P 500 Index names and then also utilizes a call-writing strategy against that index as well, with a target of being around 50% overwritten. This option premium received can help the fund provide more regular monthly distributions to its investors.

Since our prior update early at the start of the year, the fund has delivered fairly respectable results.

The Basics

• 1-Year Z-score: -1.22
• Discount: -4.82%
• Distribution Yield: 8.15%
• Expense Ratio: 1.07%
• Leverage: N/A
• Managed Assets: $1.8 billion
• Structure: Perpetual

ETY is a fairly simple fund on the surface; the fund's policy is to "invest in a diversified portfolio of domestic and foreign common stocks with an emphasis on dividend-paying stocks and writes (sells) S&P 500 Index call options on a portion of the value of its common stock portfolio to generate current cash flow from the options premium received." Their objective with this strategy is to "provide current income and gains, with a secondary objective of capital appreciation."

When writing options, they write against an index rather than individual names. That can have its own unique differences , with its own pros and cons. They generally target an overwrite of around 50% and write options that are just out of the money, with the last fact sheet showing it coming in at 4.5% with an average day of expiration of 16.

Performance - Putting Up Respectable Numbers

The fund recently took a plunge into correction territory, but that was with the rest of the market. Over the long term, ETY can underperform due to its call-writing strategy in a strong bull market. Since the global financial crisis, that's mostly been what the equity markets have been experiencing.

2022 was the latest year to provide some volatility to the market and push it to bear market territory, which ETY was able to thwart some of the downside moves in that case. On a total NAV return basis, the fund was off -15.99 % compared to the broader market, coming in around a decline of 19%. An option writing strategy is only slightly defensive, and in a market that is moving swiftly lower, it can only do a little to stop the damage.

On the other hand, the fund's less restricted overwrite policy of 50% has meant that it also participates in more upside potentially relative to funds that overwrite to larger degrees. For example, its sister fund, Eaton Vance Tax-Managed Buy-Write Income Fund (ETB), also focuses on the S&P 500 as its benchmark but takes an overwrite target of nearly 100%. Therefore, what we would expect to see in a strong market year such as 2023 has been, for the broader market measurement has played out. That is ETB lagging behind.

What I'm actually surprised by is the fact that ETY has performed so similarly to ( SPY ) on a YTD total NAV return basis. At least for this brief period of history, the overwriting of around 50% hasn't had the usual meaningful divergence in performance.

A factor for this would likely be due to the fact that while ETY lists the S&P 500 Index as its benchmark, it takes more of a sampling approach. In total, they listed only 63 equity positions as of their Q3 2023 fact sheet .

With all that being said, the fund's historical returns have been fairly respectable nonetheless. Its function of providing regular monthly distributions is also a key focus of what makes ETY appealing for income-oriented investors.

Since our last update, the fund's discount has widened a bit further since our previous update. That makes it a more tempting fund to consider, but it still isn't necessarily in 'Buy' territory yet. If we are being picky, we want to see the fund trade down to around an 8% discount.

That level has been quite elusive for most of the last several years - however, it isn't an impossible level to reach. In fact, with last month's tumultuous market, it ever so briefly touched that level for two days during November. That was when the market started to recover hard, but the fund's share price actually moved downward for a brief period.

Distribution - Looking Healthy

The big news in our prior update was the fact that Eaton Vance had cut a number of distributions for their equity funds. That pushed funds to a fairly significant discount, but ETY's valuation was more resilient. This cut was a direct function of 2022's bear market.

The fund can deliver relatively higher distribution rates compared to equity funds because of writing calls; however, it isn't completely immune to needing capital gains derived from underlying investment appreciation to fund its payout.

Though, of course, the options premium received does help to pad some of the capital gains generally. From their last semi-annual report , the fund actually realized losses from writing options but was sitting on unrealized gains that more than offset those losses for the period. Losses can happen for a few reasons with call writing, but with ETY, they write calls against an index. Since they can't own an index directly, these are cash-settled, and if the index rises sharply, the fund will realize losses on the contracts.

Of course, the other side of this is that the underlying holdings that makeup ETY should also be seeing a general rising trend. While they aren't holding a 1 to 1 portfolio exactly that makes up the entirety of the S&P 500 Index, they are still the ones that generally have the largest influence on the index (i.e., they are heavily invested in the largest holdings of the index, and those are primarily the mag 7 names.)

Within the next few weeks, we should have the fund's next annual report available to see how they fared for the entirety of fiscal 2023. Their fiscal year-end is October, and this report was for the six months ended April 30, 2023.

Given the fund's strategy, this is how the fund intends to be "tax-managed." By writing calls against an index, they can sometimes experience losses. However, if these options end up expiring worthless, it means that equities are falling or, at the very least, they aren't appreciating. Therefore, the fund could realize losses from its portfolio to offset the gains from its options strategy. If the options strategy is generating losses, then they don't really have to make any move to realize the losses, and this will result in a distribution that can be heavy on return of capital. This is the overall general strategy of the Eaton Vance tax-managed funds.

In the case of ETY, for 2022 , it would appear they didn't really go heavy into that strategy. The distribution ended up being primarily long-term capital gains instead. Those are still taxed at favorable rates, but ROC can be even better as it is tax-deferred. It is tax-deferred because it reduces an investor's cost basis, and then it becomes only potentially due if the position is sold at a gain.

Other years had been relatively better. 2021 saw ~50% of the distribution as ROC, and in 2020 , it was over 90%.

ETY's Portfolio

Despite the fund holding significantly fewer holdings than its benchmark, the S&P 500 Index, the fund's sector weightings are nearly identical. At the very least, they are a rather negligible difference in weightings. This is important for the fund's strategy; as mentioned above, they can't hold an index directly, so having a portfolio that largely follows is important. If they didn't operate in this manner, they could have a situation where the fund's portfolio is falling while simultaneously its option writing strategy is also performing poorly.

With that being the case, it also comes with little surprise that the fund is heavily invested in the Mag 7 names. Microsoft ( MSFT ), Apple ( AAPL ), Amazon ( AMZN ), NVIDIA ( NVDA ), Meta Platforms ( META ) and Alphabet ( GOOG ) are all included, in that order, in the top ten.

These names account for 33.34% of ETY's portfolio. For these same names, they account for 26.62% of the S&P 500 Index (as of December 1, 2023 .) Given that the portfolio that ETY runs has significantly fewer names, a higher concentration makes sense. They have the same 100% to play with, but they are currently filling it up with 63 holdings.

The only Mag 7 name missing from the party is Tesla ( TSLA ). It's not listed when expanding their entire holdings list, either.

As a quick reminder for those who haven't been following the market too closely this year, these are the Magnificent 7 names because of such strong performance YTD. These are the names that have been doing much of the heavy lifting of the overall market, contributing nearly all of the gains. It's also why ETY has performed so well, too.

Conclusion

ETY has put up a respectable performance historically. Perhaps even more impressively, the fund challenged the results of the S&P 500 Index this year, even with around a 50% overwrite target. That's generally rare for a fund that writes call options while the overall market is performing impressively. Part of this would be thanks to ETY's more concentrated holdings within the Mag 7 names.

With all this being said, if we are being picky, we'd want to see the discount further widen out from here before getting too excited. Investors who were quick were able to get a really nice entry level while the market briefly touched correction territory. This was then followed up by a swift recovery where ETY's price actually dipped during the recovery to hit an attractive discount, touching our buy discount target of 8%.

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