JCE - JCE: Falling Behind In A Low Vol World

2024-01-17 06:13:11 ET

Summary

• Nuveen Core Equity Alpha Fund has underperformed the S&P 500 by almost 50% due to its option overlay strategy and low volatility levels.
• The low volatility environment has resulted in low option premiums, which do not adequately compensate JCE for market moves.
• Investing in the S&P 500 outright or choosing a different closed-end fund without an option overlay may be a better choice in the current low VIX environment.
• The CEF will remain at a discount as long as VIX levels are suppressed.

Thesis

Nuveen Core Equity Alpha Fund (JCE) is an equity closed-end fund. The fund seeks a total return profile closely matching the S&P 500 index via a portfolio of equities with an option overlay. The fund falls in the 'Large Blend' Morningstar category, focusing on 130 holdings.

JCE has disappointed in the past year, trailing the S&P 500 by a very large percentage:

We can see from the above graph an almost 50% underperformance in terms of net gains, with the SPY at 21.45%, while JCE clocked in only 12.52%. This significant underperformance has to do with the options overlay and the extremely low volatility figures currently present in the market.

In this article we are going to re-visit the JCE composition and argument why we do not think this fund is a compelling choice in today's low VIX environment.

Volatility has been crushed in the past year

One of the surprising market developments in 2023 has been the crush of the VIX:

The index spent virtually the entire year at very low historic levels, levels usually associated with bull markets. Some are speculating the low VIX levels are due to the '0DTE' construct, which has moved a significant amount of speculative action to the very front end of the curve.

Irrespective of the reason, a low VIX and thus volatility, translates into low option premiums when selling calls. JCE as a fund is a volatility seller, via its written call options:

As of the last fact-sheet, the CEF had written calls on 31% of its portfolio, with a 5% out of the money strike level. The calls are written on a rolling 30-day period on average. While the overall structure is correct (front dated overlay so the fund can take advantage of theta decay), the option premiums in today's VIX environment do not sufficiently compensate the fund for the current market moves.

Volatility is the main pricing component for an option, and when volatility is low, the option premium is very small. Let us take an example. Using a Black-Scholes options pricing model we did the following:

1. Priced a 475 strike SPY call with a 30 day expiry at the current implied volatility levels. The obtained option premium was $4.9
2. Priced the same SPY call with a much larger implied volatility of 25. The obtained option premium was $11.8

By simply moving the VIX levels to historic averages as seen from the above graph, we got an option premium more than double the size of the current one. A low option premium simply means the CEF will not be compensated sufficiently when the market rallies fast in a short period of time. A rapid rise in equity prices means the calls will be triggered, but the premium received by the fund does not make up for the upside that was given up in the rally.

The only situation where call-writing works in the current VIX environment is one where realized volatility matches the low implied one. That translates into investors needing very moderate smooth moves in the indices in order to have a CEF performance that matches the index.

Various ways to extract dividends via the CEF structure

A CEF structure simply transforms equity market returns into dividends. There are several ways to doing that. Let us take the simplest possible example. Let us say we set up a CEF, and we completely replicate the S&P 500 by buying the underlying 500 stocks. And let us assume at the end of the year the index is up 9%. All we need to do is sell a small slice of our holdings, equating to the 9% capital gain, and then distribute that to shareholders. In this fashion we have created a 9% yielding CEF with an annual distribution (ignoring here any management fees).

The same feat though can be achieved via a more complex undertaking, where instead of buying 500 stocks a manager can buy just 130 (thus taking a view on a slice of the portfolio), and instead of selling stocks once a year the manager can choose to sell options monthly. In a normalized environment, the option premium can serve as the bulk of the distributable dividend. At the end of the day it is achieving the same result, but using a different financial engineering take on the structure.

Option 1 described above is preferable in a low VIX environment, while Option 2 is preferable when volatility is high or normalized. In the current environment, with a historic low VIX, Option 1 will create a total return profile much closer to the index performance. From a structure standpoint, a retail investor would actually do much better by just purchasing the S&P 500 outright via an ETF like SPY.

Premium/discount to NAV performance

The CEF had a premium to NAV during the volatile days of 2022:

That premium moved to a discount as we entered 2023 and a very low VIX environment. Basically the market is telling us the same story as described above. In a low VIX environment, it is better to enter equities via an ETF outright or a CEF which does not utilize options. We expect JCE to remain at a discount to NAV as long as VIX levels remain depressed.

Analytics

• AUM: $0.2 billion
• Sharpe Ratio: 0.45 (3Y)
• Std. Deviation: 16.2 (3Y)
• Yield: 9.8%
• Premium/Discount to NAV: -2.5%
• Z-Stat: -0.4%
• Leverage Ratio: 2%
• Duration: n/a

Conclusion

JCE is an equities CEF. The fund seeks a total return that matches the S&P 500 profile. JCE utilizes options on a portion of its portfolio (up to 50% overlay) in order to generate some of its dividend yield. In today's low VIX environment, this option overlay strategy has backfired, with the received premiums not sufficient to compensate the fund for the realized volatility moves. The fund is up only 12% in the past year versus 21% for the SPY, mainly driven from the low VIX levels and the covered call strategy. As long as VIX stays suppressed, this strategy will underperform. The market is telling us the same story, having traded the CEF from a large premium in 2022 when VIX was high, to a discount currently. Expect the discount to persist as long as the VIX is low. At this time we would trade out of JCE and either buy the SPY outright or for dividends choose a CEF which does not use an option overlay.

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