Written by Nick Ackerman, co-produced by Stanford Chemist. This article was originally published to members of the CEF/ETF Income Laboratory on May 2nd, 2023.
After a tough 2022 for the Eaton Vance Enhanced Equity Income Fund II (NYSE:EOS), 2023 looks quite a bit better. At the same time that the fund is starting to perform better, its share price is actually lagging behind its underlying portfolio. EOS was one of the many equity Eaton Vance funds that cut their distribution last year. However, it took a bit longer for this one to move to a discount than the others.
After our last update, performance actually hasn't been too terrible. However, getting to where we are today has been quite a wild ride. The below also only reflects the share price results and not what the actual underlying NAV is doing through this time.
The last time we updated the fund, it was at a shallow discount, and today it's at around a 5.5% discount. Meaning that the NAV has been outperforming the share price during this time and opening up an opportunity for investors to add to this name potentially. The fund has had periods of trading at some larger discounts. However, the fund has historically generally traded closer to NAV or even at premiums in recent years. The fund utilizes an options writing strategy and is not leveraged.
The Basics
- 1-Year Z-score: -2.12
- Discount: -5.44%
- Distribution Yield: 8.47%
- Expense Ratio: 1.09%
- Leverage: N/A
- Managed Assets: $895.4 million
- Structure: Perpetual
EOS's primary investment objective is "to provide current income, with a secondary objective of capital appreciation." To achieve this, "the fund invests in a portfolio of primarily large- and mid-cap securities that the investment advisor believes have above-average growth and financial strength and writes call options on individual securities to seek to generate current earnings from the option premium."
They typically target around 50% of their portfolio being overwritten. The less the portfolio is overwritten, the more positions are left to "fly higher" in a bull market. Utilizing a covered call strategy in a bull market can generate lagging returns relative to a non-option strategy fund. As overall markets appreciate, the underlying positions can either get called away. Managers may also choose to close the position, which can result in some losses.
However, that can be precisely what some investors find attractive about this fund, too, as it isn't leveraged. That should relatively decrease risks compared to its leveraged CEF cousins. It also means that even in a flat market, the options writing strategy can generate returns to help fund the distribution.
Performance - Attractive Discount
After having a tough 2022, the fund is off to a much better start in 2023. That's because the portfolio is heavily allocated to the mega-cap tech names and growth investments, in general. YTD in the below table is through the end of April 2023.
However, one area that I like to check now for covered call funds is 2022's results compared to a benchmark. The main reason is that a covered call fund should have provided a softer blow relative to a non-option writing benchmark. 2022 is important because it was over the course of a whole year that things were weak in the market. It wasn't like COVID, where the crash and recovery were incredibly fast. The option writing gains didn't really have a chance even to offset any losses as it was only a short period of time.
In this case, the EOS benchmark is the Russell 1000 Growth Index. Fortunately, we have the iShares Russell 1000 Growth ETF (IWF) for comparison. And, to be honest, I'm quite disappointed with EOS in this regard. As we can see, the fund's total NAV returns only moderately outpaced this comparison ETF.
First, portfolio positioning is incredibly different. Despite EOS benchmarking against this index, they only hold 56 positions. IWF holds 509, which itself is still well below the ~1000 holdings in the actual index. So both investment vehicles use a sampling strategy to mimic the benchmark. However, IWF clearly has much more room to make an error in its tracking relative to EOS with its minimal holdings.
Secondly, this was over the course of a whole year, so the fund's expense ratios played a bit of a role too.
Still, I think the most attractive part of EOS is the fund's ability to exploit the discounts/premiums. Not to mention that the distribution rate is significantly higher than it would otherwise be with IWF. It distributes out gains instead of only the income it receives that an ETF traditionally does.
Going back to the fund's inception, the fund has traded at premiums many times. The average discount for the fund is quite shallow overall. It was mostly after the GFC that the fund experienced most of its longest period of trading at an extended discount.
Distribution - 2022 Cut Leaves It More Sustainable Now
One of the catalysts that saw EOS and the other Eaton Vance funds fall was a distribution cut in the prior year. Due to a weak market, capital gains just weren't there. Equity funds regularly rely on capital gains to fund their distributions. It actually took a bit longer for this to play out for EOS as there wasn't an immediate reaction as the fund's discount has only now recently been opening up.
I've personally become less sensitive to distribution cuts for CEFs, but I know others for others it can make them a complete avoid. That can sometimes provide opportunities for investors who look for cuts to swoop in at better valuations. Overall, the fund's distribution yield of 8.47% is quite attractive. At a NAV rate of 8%, it appears reasonable as well.
Worth noting for this fund is that they don't only heavily rely on capital gains to fund their distribution, but that's the entire coverage of their distribution. With a significant growth/tech-focused portfolio, they don't generate any net investment income after expenses are paid.
That can make them even more sensitive to overall market changes in terms of declines or appreciation. Looking at the fund's option writing gains, we can see they generated $28.326 million from that strategy. That contributed to more than half of the capital gains the fund realized in the last year.
This helps highlight why covered calls can be a slightly defensive strategy. It is this pool of gains that IWF wouldn't have realized that should have propelled EOS to perform even better in an extended downturn.
The remainder would have been from investment transactions of realizing gains in the underlying portfolio. Of course, we can see that the fund's unrealized depreciation was significant, which no doubt contributed to their decision to cut the payout to investors.
The fund's tax character is mostly made up of long-term capital gains. However, return of capital would have also made up some of the distribution. For 2021, this wouldn't have been bad ROC, while 2021 would have been some destructive ROC. Even 'bad' ROC isn't all bad, as it defers an investor's tax obligation in a taxable account due to reducing one's cost basis. Ordinary income could have been generated in 2022 due to covered calls often producing short-term capital gains.
EOS's Portfolio
The portfolio turnover has been fairly muted in the last couple of years. For 2022, it was the lowest in the last five years at 15%. In the last five years, they were most active in 2018, with a 44% turnover rate. Overall, the portfolio doesn't tend to experience significant changes. So even when the fund only posts its sector allocation in the annual and semi-annual reports, the actual breakdown tends to stay fairly static. This was from the end of 2022.
It looks quite similar to the breakdown at the end of 2021, with tech at a weighting of 43.1% at that time. Consumer discretionary at that time was also 16%. There were some differences between healthcare previously at 12.4% and communication services at 13.9%. Communication services were the largest difference in terms of absolute changes over the last year. That can be worth noting because healthcare can be a defensive area, while communication services have been more volatile.
Fortunately, they provide a breakdown of top holdings that's much more recent; the list of the top ten below is from the end of March 2023.
These names are also quite familiar and reflect the minimal changes we saw in overall sector allocations over the course of a year.
Microsoft (MSFT) is the largest holding, followed by Apple (AAPL). AAPL made its way from the fourth largest position at a 6.68% weighting to a weighting of 7.34% now, leapfrogging Alphabet (GOOG) and Amazon (AMZN) that previously topped it at weightings of 7.86% and 7.85%, respectively.
Regardless, we clearly see that the overall fund will be heavily skewed toward these mega-cap tech names. The percentage weightings overall didn't change dramatically from April 2022 of last year, even with a bit of reshuffling.
Outside of those tech names, NVIDIA (NVDA) also has made an appearance in the fund's top ten when it wasn't previously. At the end of 2022, they held 57,366 shares of NVDA. Mid-2022 is when NVDA shares first appear in the June 30th N-PORT with 37,338 shares. It appears they added at an opportune time, too, to take advantage of a massive rally heading into 2023 for NVDA. In the last year, this has pushed NVDA to top even the relatively stronger performing mega-cap MAMAA (Microsoft, Apple, Meta, Amazon and Alphabet) names.
Worth noting, of the MAMAA names, Meta Platforms (META) is not included since going back to the March 2022 N-PORT filing. META is a position in the communication services sector. Perhaps unsurprisingly, that's why we could have seen the decline in communication services sector exposure for EOS.
Conclusion
EOS had a tough year in 2022 due to its significant weighting to growth and tech. However, this has been on a solid rebound heading into 2023. It is anyone's guess if this sort of rebound can continue in these mega-cap tech names. What we do know today is that the fund's discount is more appealing than it was through most of the last five years. This has occurred as the funds' underlying portfolio is rapidly rising while the fund's share price continues to languish; that's exactly the opportunities that CEF investors often seek out.
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