VT - EXG: Global Equities At A Large -10% Discount

2023-12-07 05:20:59 ET

Summary

• EXG is an equity closed-end fund utilizing written options to extract dividends from its equity portfolio.
• Over a 10-year period, EXG has tracked closely with the Vanguard Total World Stock ETF, with periods of outperformance.
• The Fund's strategy involves writing call options, which works better when volatility is high. The current low volatility environment has resulted in a widening of the discount to NAV for EXG.
• The analysis suggests that buying EXG at a discount may be preferable to purchasing equities directly through an ETF like VT, especially considering the potential for the discount to revert to zero when volatility increases, offering an estimated additional +10% return.

Thesis

The Eaton Vance Tax-Managed Global Diversified Equity Income Fund ( EXG ) is an equity closed-end fund. The vehicle falls in the buy-write category, utilizing written options to extract dividends from its portfolio of equities. The CEF is a robust long-term performer that has recently opened up a historic discount to net asset value.

The CEF is a large $2.3 billion AUM vehicle from Eaton Vance, which we covered around six months back when we were of the opinion the fund is a hold at the respective levels. The fund has been flat on a total return basis since our last article, with the gains in the underlying portfolio offset by a widening of the discount to NAV. For full disclosure purposes, we are long this name in our own portfolio, as highlighted in the Seeking Alpha disclosures.

In this article, we are going to look at the drivers behind the historic discount to NAV which has opened up, and analyze if it makes sense to increase exposure to the global equity market at the current levels.

Investors do not like the short vol positioning

EXG has recently opened up a historic discount to net asset value:

On a 10-year lookback, the fund is close to its all-time lows in terms of discount to NAV. The CEF has moved swiftly from a premium to NAV in 2022 to a large discount in 2023. We believe this is due to its intrinsic short-volatility positioning. When a CEF writes calls it is short vega, or volatility. As with any other asset class, volatility is traded, and an investor should buy low and sell high. Currently, EXG is doing the opposite:

The VIX is at historic low levels on a 5-year look-back, which intuitively points towards an asset class that should be bought, not sold. EXG however is structurally set up to monetize equities via written call options, rather than speculate on vol. This set-up works better when vol is high since the option premium received is higher.

Is the discount justified?

The fund has proven long-term that it is a robust tool to extract dividends from the global equities markets:

On a decade-long basis, the CEF closely tracks the total return exhibited by the Vanguard Total World Stock ETF (VT), with many periods of outperformance. For example, from 2016 to 2020 we can see how EXG outperforms VT, with the orange line higher than the teal one representing VT.

Currently, the discount is justified given the low vol environment, but we fully expect it to revert to flat once volatility picks up again.

The fund has taken some steps to address the current macro environment, via a lower overwrite percentage and a higher 'out-of-the-moneyness':

Currently only half of the portfolio is covered by calls, and the respective options are 4.3% out-of-the-money. The average days to expiration is 16, meaning a very quick turnaround in the portfolio. The fund needs a 4.3% up move in a two week period (on average) for the options to attach.

As a reminder, theta or time decay, is the highest in the last 30 days of an option's life. Theta measures the loss in value that options experience as time passes. Setting up a strategy with a sub-30 day turnaround period ensures theta decay is maximized, thus a counterbalance for a low IV level.

Buying equity outright versus a discounted CEF

We are of the opinion that in the current environment buying global equities via a discounted CEF like EXG is preferrable to an outright purchase. While the discount is not going to close until we get volatility back, it will however indubitably move back to flat. To that end, on a 12-month time frame, we see the discounting narrowing to zero, which should provide for a 10% return backwind. Conversely, an investment directly into an ETF like VT will be purely driven by market prices, with no additional gains.

We understand why the market is punishing EXG with a discount, and are of the opinion that the low historic discount should be purchased rather than sold. There are many opinions floating in the market right now, with some analysts predicting a strong bull in 2024, while others see the current rally as ephemeral. JP Morgan is in the bear camp with a 4,200 price target on the S&P 500, while Bank of America is bullish with a 5,000 price target. Whichever direction the market pursues, an ultimate pick-up in volatility will help EXG narrow that discount and provide retail investors with an additional 10% total return.

Managed distribution

The fund currently displays an 8.6% dividend yield which is the result of a managed distribution plan:

As per the CEF's literature:

the fund currently makes distributions in accordance with a managed distribution plan. As of 03/31/2023, distributions include amounts characterized for federal income tax purposes as ordinary dividends (including qualified dividends), capital gain distributions and estimated non-dividend distributions, also known as return of capital distributions.

A managed distribution plan is appropriate for this fund since it has had a very stable NAV throughout time:

For equity CEFs that record long-term annual returns in excess of 8%, setting up a managed distribution makes sense since over long periods of time the fund will make up via NAV accretion the periods when the underlying options premiums were not sufficient for the distribution payments.

Should you buy a CEF or an ETF?

We have gone through the reasons behind EXG's discount in the sections above and highlighted why we believe there is a 10% positive return to be crystalized once volatility picks up again. However, broadly speaking, equity buy-write CEFs are set up as systematic vehicles to extract dividends from the underlying risk factors, in this case, global equities returns. EXG has proven to be able to do that very well throughout the past decade, and it will continue to do so. If you are an investor looking for yield, EXG is the appropriate tool to use. If as an investor you are searching for capital gains rather than yield, VT is the more appropriate choice.

EXG however has demonstrated its worth in actually outperforming VT during certain historic periods, so in addition to the 10% discount, it also offers the potential for management outperformance for future periods.

Conclusion

EXG is an equities CEF. The fund tracks global equities, and throughout the past decade has represented a robust way to extract dividends from global stocks, closely tracking the VT fund's total returns. Currently, EXG has an option overlay on half of its portfolio, with a 4.3% out-of-the-money average on its options. The fund's discount to NAV has widened significantly due to its short vega stance, with the market penalizing the CEF for low overall VIX levels. Long-term however vol is going to resurface and the fund will close the gap on its discount, with retail investors getting a +10% benefit versus investing in VT outright. While opinions are mixed on how 2024 is going to shape up for equities, we are in the camp that believes volatility will resurface, allowing EXG to benefit from closing its discount. We are therefore buyers of EXG here versus a position in equities via an ETF like VT.

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