RSP - HEQ: Joins The Penalty Box

2023-09-21 14:17:52 ET

Summary

• John Hancock Hedged Equity & Income Fund joins the penalty box of distribution cutters, leading to a deep discount.
• Limited recovery in the broader market outside of mega-cap growth names keeps pressure on equity funds invested more broadly.
• HEQ's low beta and derivatives hedge strategy may limit downside risk, but caution should be considered as I don't believe this is a buy-and-hold type of fund.

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

John Hancock Hedged Equity & Income Fund ( HEQ ) joins the penalty box of distribution cutters this year. While the cut was announced earlier this year, there was a delayed reaction until after the ex-distribution date, when the fund fell off a cliff to a deep discount.

This isn't too dissimilar to its sister fund, John Hancock Premium Dividend Fund ( PDT ), which cut and found itself in a sell-off that significantly widened its discount to NAV per share. Of course, this is generally when the opportunities become available for investors to scoop in and pick up a position at a deep discount.

The Basics

• 1-Year Z-score: -2.58
• Discount: -15.72%
• Distribution Yield: 10.36%
• Expense Ratio: 1.15%
• Leverage: N/A
• Managed Assets: $140.13 million
• Structure: Perpetual

HEQ's investment objective is to "seek total return consisting of both income and capital gains." To achieve this, the fund will invest "at least 80% of the portfolio in a diverse selection of equities across market capitalization." To manage the downside risks, the fund employs "options strategies to mitigate capital losses in periods when equity markets decline."

Here, we are dealing with a small fund, which can make it incredibly difficult for larger investors to get any sort of substantial position when buying. It can then make it harder for such a position to be unwound.

Distribution Cut Puts The Fund In The Penalty Box

2023 is starting to be a year of crowding in the penalty box. However, it isn't necessarily unexpected given the market we had experienced in 2022 when equities and fixed-income both fell dramatically. Additionally, outside of the handful of names that are driving most of the results this year, it isn't as if the broader market is really experiencing a significant recovery.

If we look at the Invesco S&P 500 Equal Weight ETF ( RSP ), that ETF is up just over 4% on a YTD basis. It's the S&P 500 Index that holds an overweight position in the mega-cap growth names that's really driving most of the results we see through 2023.

Therefore, we've experienced limited recovery elsewhere outside of those names, and that doesn't bode well for closed-end funds and their higher-than-usual distributions. As they aren't like traditional corporations that can retain earnings for a cloudy day and the yields are already high, it leaves little room for cushion.

Here's what I had to say about HEQ's distribution in our previous update:

The fund currently sports a distribution yield of 11.03%. That's quite tempting, and thanks to the fund's significant discount, this is higher than the 10.03% the fund has to earn to cover it. Of course, history shows us that since the fund's launch, it hasn't been able to earn this distribution.

HEQ is a case of another CEF that wasn't earning its distribution but still continuing to pay it. So, I was ultimately pretty cautious even for this "tempting" distribution.

That article was originally published on June 22, 2023 . It was only then, on July 3, 2023 , that they announced the quarterly distribution was being cut from $0.29 to $0.25. In the grand scheme of things, it actually wasn't that material of a cut compared to some of the other offenders we've seen this year.

At the time of our update, the discount was close to 8%. Even after the announcement, the fund didn't actually really budge all that much from that level. Instead, the sell-off really only started to take place after the ex-distribution date on September 8, 2023. That's where we are now, with a fund at a substantial discount.

Over the history of the fund, there have been times when the discount was as substantial as it is now. However, this does mark now one of the largest discounts the fund has ever traded at. Outside of Covid, in 2016 it looks like it was also near this current level. That doesn't necessarily mean that the fund can't go to a larger discount, but it could be nearing a floor.

Even after the fund's distribution cut, the actual distribution rate isn't all that different from where it was before. When we last covered the fund, the distribution rate was right around 11%. After the big drop, it's still around 10.4%. With that being said, the fund's NAV rate is coming in at 8.73%. That still suggests that if history is any guide, the payout still wouldn't be covered.

Over the last decade, total NAV performance has come to around 5.04%. Since its inception in mid-2011, it comes in at around 5.29%. Some sliver of hope is that over the last 3 years, the annualized results have shown a total NAV return of 8.95%. That suggests that during this time, the fund would have been able to cover this level of payout.

Low Beta And Derivatives Hedge

At the end of the day, it is mostly an equity fund that will require capital gains to fund their payout. So, it would depend on one's outlook moving forward based upon the portfolio if one believed they could continue to achieve this level of performance. Additionally, the fund incorporates derivative strategies as a way to "hedge" itself. The derivatives used are writing index calls and also incorporating futures trading.

It's certainly a low-beta portfolio at 0.62, and this is achieved with mostly defensive-type names. Healthcare is a big representation in the fund's top holdings.

However, if we look at sector weightings, financials are the largest allocation overall at 23.57% weight. Healthcare's representation of the portfolio comes to 10.49% for comparison.

This positioning and strategy of the fund worked out incredibly well in 2022's bear market. The fund still experienced some substantial declines in October, but overall, the losses were relatively limited if we compare it to RSP and the SPDR S&P 500 ETF ( SPY ) for the year.

Conclusion

I think that my conclusion from the previous update remains relevant here as well; "that said, I don't view HEQ as a long-term buy-and-hold position but one that should be traded tactically." This remains the case, and if one suspects equities are going to head lower, the low beta and derivatives approach that HEQ utilizes to hedge could keep the downside limited.

Additionally, the fund's deep discount on an absolute and relative basis also makes it more of an interesting fund to consider at this time. However, this deep discount appears to be on the back of a distribution cut that has put yet another fund in the penalty box for 2023. Though this one was more of a delayed reaction until more recently, after going through its ex-distribution date.

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