Summary
- Investors today are desperate for income to help overcome the ravages of inflation.
- ETY generates income by investing in a portfolio of stocks and then writing indexed call options.
- The fund is very concentrated in a few technology stocks that have underperformed the S&P 500 year-to-date.
- The fund is covering its distribution but recent capital losses forced it to cut the distribution.
- The fund is trading at a premium to the net asset value today so it is somewhat overpriced.
Without a doubt, one of the biggest problems facing Americans today is inflation. The current official rate is at a higher level than most of us can remember and this has been the case all year. This situation has led many people to begin working second jobs or actively seeking alternative sources of income just to keep themselves fed and maintain their standard of living. Fortunately, as investors, we have better options available to us to increase our incomes. One of the most effective of these is to purchase shares of a closed-end fund that specializes in the generation of income. These funds enjoy the benefits of professional management that can, in many cases, use certain strategies that can boost their yields far beyond those of any of the underlying assets. In this article, we will discuss the Eaton Vance Tax-Managed Diversified Equity Income Fund ( ETY ), which is one such fund that can be used for this purpose. This fund yields an impressive 8.43% as of the time of writing, which is certainly high enough to attract most income-seeking investors. As some readers may recall, I have discussed this fund before, but more than a year has passed since that time so obviously a great deal has changed. This article will therefore focus specifically on those changes as well as provide an updated analysis of the fund’s finances.
About The Fund
According to the fund’s webpage , the Eaton Vance Tax-Managed Diversified Equity Income Fund has the stated objective of providing investors with current income and gains with a secondary focus on long-term capital appreciation. This is not unusual as most equity funds that focus primarily on providing investors with income have similar objectives. The strategy that this fund uses is a bit unusual, however. In short, the fund invests in both domestic and foreign stocks in an attempt to build a diversified portfolio. It then sells call options against the S&P 500 index ( SPY ). The goal is to have the options expire worthless so that the fund can keep the option premiums. It is a decent income strategy when it works, although it would be nice if the fund included in its name that it is an option-income fund and not a fund that is trying to derive income from dividends or something like that.
The fact that this fund uses an options strategy may scare some investors as we have all heard numerous reports about the dangers of options. It is certainly true that some options strategies can be incredibly risky as the potential losses can be unlimited. After all, someone that wrote a one-year $60 call option on Tesla ( TSLA ) back in January 2020 would have been out a lot of money if the option was exercised a year later. As I discussed in a recent article though, writing call options can be reasonably safe if the person writing the option actually owns the underlying stock. This is not the strategy that this fund is using, however. The Eaton Vance Tax-Managed Diversified Equity Income Fund is writing call options against the S&P 500 index but it does not actually own the index. Thus, this strategy can set it up for fairly significant losses depending on how the market performs relative to the fund’s portfolio. We saw that happen in a few cases this year as the large technology stocks have fallen substantially more than the index over the past ten months. Eaton Vance funds in general tend to have an enormous weighting toward the mega-cap technology funds, which has certainly not done any favors for the funds that are using an index call option-writing strategy. We will see this in a bit.
As just stated, Eaton Vance’s closed-end funds tend to have a high concentration on large technology firms. This is the case with this fund as well:
CEF Connect
The presence of any of these stocks is something that does not make much sense for an income fund. After all, Alphabet ( GOOG , GOOGL ) and Amazon ( AMZN ) pay no dividends and so cannot provide the fund with any current income. These two stocks alone account for 9.25% of the fund’s assets. Apple ( AAPL ) and Microsoft ( MSFT ) account for another 16.12% and while they do pay dividends, the yields on both of them are so low that it hardly matters. So we very quickly see that fully 25.37% of the fund’s assets are invested in stocks that do little to help it accomplish its objective of providing investors with current income. Another major problem here is that all of these stocks have underperformed the market year-to-date. This is shown here:
Company | YTD Performance |
Apple | -23.97% |
Microsoft | -33.86% |
Alphabet | -40.24% |
Amazon | -46.61% |
For comparison, the S&P 500 index is down 21.22%. The fund’s heavy exposure to these stocks is probably why it is down 23.40% year-to-date, although admittedly it is holding up much better than would be expected, given the disappointing performance of its four largest holdings. In fact, the fund is beating the S&P 500 index when we consider the distributions as part of the return. The fund’s strategy of writing call options against the S&P 500 is almost certainly helping to hold it up because in a bear market the probability increases that the call option will expire worthless, which allows the fund to keep the option premium and write a new option. That option premium provides the fund with a bit of a return to offset the capital losses in the actual portfolio.
As I have pointed out in numerous recent articles, the energy sector has been the best performing in the S&P 500 index year-to-date. We can see this in the fact that the iShares U.S. Energy ETF ( IYE ) is up 58.29% since December 31, 2021. Yet for some reason, the Eaton Vance Tax-Managed Diversified Equity Income Fund has very little exposure to it. Only 5.55% of the fund is invested in the sector, about half of which is in Chevron ( CVX ) stock:
I do somewhat get what the fund’s management is trying to accomplish. It appears that they are attempting to create a portfolio that should perform somewhat similarly to the S&P 500 index using a much lower number of stocks. The Eaton Vance fund only has 69 holdings. However, considering that information technology has been substantially overvalued relative to its actual contribution to the United States economy for many years (see here ), we have to ask if this is really the best strategy for the current economic conditions. If the fund were to change its portfolio around, it would almost certainly be delivering a much better performance. In effect, the fund appears to still be running a strategy that worked pretty well prior to 2021 but has not adapted to the new reality.
Curiously though, with the exception of the four large technology stocks, the Eaton Vance Tax-Managed Diversified Equity Income Fund has changed its holdings pretty dramatically over the past year. For example, JP Morgan Chase ( JPM ), Danaher ( DHR ), Visa ( V ), Eaton Corp. ( ETN ), and Texas Instruments ( TXN ) were replaced by PepsiCo ( PEP ), Chevron, Eli Lilly ( LLY ), Procter & Gamble ( PG ), and Mastercard ( MA ). This may lead one to think that the fund has a very high turnover rate but this is not the case. In fact, the fund only has a 36.00% turnover, which is very low for an equity fund. The reason why we generally like a low turnover is that it helps to keep expenses down. After all, trading stocks or other assets costs money that is ultimately billed to the investors. This is one of the reasons why index funds have become so popular since they only do minimal trading and thus have relatively low expenses. This does not necessarily mean that a fund that does a lot of trading will underperform but it does certainly make things more difficult for the fund managers. With that said, this fund is not particularly high so it should not be passing on too much in the way of trading costs.
As stated earlier in this article, the fund states that it invests in both domestic and foreign securities. However, all of the companies listed in the largest positions list are American firms. This is common throughout the rest of the portfolio as the fund has almost no exposure to non-American companies:
CEF Connect
This is not necessarily a problem, but the fund’s fact sheet makes it sound as though this is a global fund. However, 97.79% of the fund’s assets are invested in American companies and the fund writes call options against the S&P 500 index, which is an American stock index. Thus, this should not be thought of as a global fund despite what the literature says. The Eaton Vance Tax-Managed Diversified Equity Income Fund is a domestic option-income fund. Investors should structure the remainder of their portfolio appropriately to ensure sufficient international diversification.
Distribution Analysis
As stated earlier in this article, the Eaton Vance Tax-Managed Diversified Equity Income Fund has the stated objective of providing its investors with a high level of current income and current gains. As such, we can assume that the fund would boast a relatively high distribution yield. This is indeed the case as the fund currently pays out a monthly distribution of $0.0805 per share ($0.966 per share annually), which gives it an 8.43% yield at the current price. The fund has been reasonably consistent about its distribution over the years, although it did cut it recently to its lowest level of all time:
The fund’s general consistency will likely appeal to those investors that are looking for a safe and steady source of income to use to pay their bills, although the recent distribution cut is certainly not nice to see during a time when we all need more income to overcome inflation. Another thing that more risk-averse investors may find worrisome is that a relatively high proportion of the fund’s distributions are considered to be a return of capital:
The reason why this may be concerning is that a return of capital distribution can be a sign that the fund is returning the investors’ own money back to them. This is obviously not sustainable over any sort of extended period. However, there are other things that can cause a distribution to be considered a return of capital. These things include the distribution of unrealized capital gains or the distribution of money received from certain types of options strategies. Thus, it is important that we analyze the company’s finances in order to determine exactly how it is financing these distributions and how sustainable they are likely to be.
Unfortunately, we do not have a particularly recent report to consult for that purpose. The Eaton Vance Tax-Managed Diversified Equity Income Fund’s most recent financial report corresponds to the six-month period ending April 30, 2022. As such, it will not include any information about how the fund performed during the volatility that we have seen over the past half-year. However, it is still a much more recent report than we had available the last time that we reviewed the fund so it should still be able to provide us with a reasonable amount of insight. During that six-month period, the Eaton Vance fund received a total of $14,557,367 in dividends from the assets in its portfolio. It paid its expenses out of this amount, leaving it with $3,327,493 available for investors. This was obviously nowhere close to enough to cover the $86,737,139 that the fund actually paid out in distributions over the period though. This is certainly something that may concern many investors.
However, the fund does have other ways to obtain the money that it needs to cover the distributions. One of these ways is through the use of capital gains. The fund generally failed at this during the period, however. It realized net gains of $143,644,297 over the six-month period but this was more than offset by $377,760,672 unrealized capital losses. Overall, the fund’s assets declined by $287,367,461 after accounting for all inflows and outflows. With that said though, the fund did make enough money through realized capital gains to cover all of the distributions that it paid out. However, we need to keep an eye on the fund’s unrealized losses as if it continues to suffer them, it will likely be unable to generate enough realized capital gains to maintain the distribution. This could be one reason why the fund was forced to cut its distribution recently.
Valuation
It is always critical that we do not overpay for any asset in our portfolios. This is because overpaying for any asset is a sure-fire way to generate a suboptimal return on that asset. In the case of a closed-end fund, the usual way to value it is by looking at the fund’s net asset value. The net asset value of a fund is the total current market value of all the fund’s assets minus any outstanding debt. It is therefore the amount that the shareholders would receive if the fund were immediately shut down and liquidated.
Ideally, we want to buy shares of a fund when we can acquire them at a price that is less than the net asset value. That is because such a scenario implies that we are obtaining the fund’s assets for less than they are actually worth. That is not currently the case with this fund. As of November 4, 2022 (the most recent date for which data is currently available), the Eaton Vance Tax-Managed Diversified Equity Income Fund had a net asset value of $11.19 per share but the shares currently trade for $11.48 each. This gives the fund a premium of 2.59% to the net asset value at the present price. This is a more attractive price than the 5.63% premium that the shares have had on average over the past month but it is still a premium and it is not generally a good idea to buy a fund at a premium. It may be a good idea to wait until the shares drop to a more reasonable price before buying in.
Conclusion
In conclusion, the Eaton Vance Tax-Managed Diversified Equity Income Fund provides an opportunity for investors to boost their incomes in order to help maintain their standard of living in today’s inflationary world. However, the fund has some flaws such as its heavy exposure to a few large-cap technology stocks and limited exposure to better-performing sectors of the market. The fund is suffering from a declining net asset value because of this and had to cut its distribution recently in response. When we combine this with the fact that it is currently trading at a premium, it is not nearly as attractive today as it looks at first glance.
For further details see:
ETY: Not Nearly As Attractive As It Looks