This has certainly been a very interesting year for the markets. In the early months of the year, the COVID-19 pandemic swung stocks into a very solid bear market, with March being one of the worst months on record since the Lehman Brothers collapse of 2008. The Federal Reserve fairly quickly followed up unprecedented stimulus and Congress certainly assisted this by flooding the country with an enormous quantity of new money (over $4 trillion has been spent battling the COVID-19 fallout so far). This has been enough to push stocks back into a raging bull market even as the real economy confronts a 6.90% unemployment rate and millions of people face food insecurity. There are some very strong indicators that the market has gotten ahead of itself and now has entered overvalued territory. It, therefore, might be a good idea for investors to protect themselves from the event of a possible reversal. One way to do this is to purchase a position in the Eaton Vance Risk-Managed Diversified Equity Income Fund (ETJ), which also happens to sport a 9.17% distribution yield.
As mentioned in the introduction, this has been a very interesting year for the stock market. Following the pandemic-related crash, the market responded very positively to an unprecedented surge of fiscal and monetary stimulus, although as I pointed out in a previous article, most of that performance was driven by only a few stocks. The bullish trend resumed last week following the media’s declaration of Joe Biden as the election winner. Overall, the S&P 500 is up 9.55% year-to-date:
As mentioned though, the real economy can hardly justify this confidence. The official unemployment rate currently sits at 6.90% due to the lingering effects of the pandemic-related shutdowns, which have still not been lifted in many states. Thus, we have a raging bull market when a sizable percentage of the population is wondering how they will be able to eat, let alone engage in any consumer spending. When we consider that consumer spending accounts for around two-thirds of the American economy, it should be easy to see a problem here.
One of the more widely-known metrics for valuing the market is the cyclically-adjusted price-to-earnings ratio, or CAPE ratio. This ratio was popularized by Yale University professor and Nobel laureate Robert Shiller in this book Irrational Exuberance to explain the 2000 stock market bubble but it greatly predates him. In fact, Benjamin Graham and David Dodd suggested using it in the 1934 book Security Analysis. The CAPE ratio at its core is designed to smooth out variations in a company’s earnings per share due to fluctuations in the business cycle. It does this by averaging the company’s real inflation-adjusted earnings over the trailing ten-year period and then comparing them to the stock’s price. As with the regular price-to-earnings ratio, if this value is above average, then it could be a sign that the stock or market is overvalued and vice versa. As of the time of writing, the S&P 500 index has a CAPE ratio of 32.37. Here is how that ratio has varied throughout history:
As we can see here, the market is currently much more richly valued than its historical average. It is also above its pre-crash valuation preceding every major market crash in history except for the 2000 tech bubble. This is a sign that the market could be overvalued relative to the actual earnings of the component companies. This could be a dangerous situation.
The stock market not only appears overpriced relative to corporate earnings but also relative to the nation’s economic output. One of investing legend Warren Buffet’s favorite measures of value is the total market cap-to-GDP ratio, which he once described as “probably the best single measure of where valuations stand at any given moment.” As can probably be expected, this measure can be calculated by comparing the total market cap of all American companies to the U.S. gross domestic product. As of the time of writing, the U.S. total market index stands at $36.594 trillion, which is 173% of the last reported gross domestic product figure. This is the highest level in history:
This ratio is actually a very good indicator of future market performance because it tends to revert to its average over time. There is actually a very simple formula that we can use to project forward returns based on this fact. Here it is:
Investment Return (%) = Dividend Yield (%) + Business Growth (%) + Change of Valuation (%)
Dividend yield is fairly obvious and business growth in aggregate is equal to GDP growth over the long term. At this point, some readers may argue this point and illustrate a company that has managed to grow its earnings faster than GDP. For every company that does this though, another one sees falling earnings. In aggregate, all the companies together can only grow earnings at the same speed as the economy. This is simple common sense. The final figure is harder to determine but if we consider that the ratio historically reverts to the mean, we get a projected total return of -1.7% over the next eight years. As few investors genuinely want to lose money, we can conclude that it makes sense to protect yourself.
About The Eaton Vance Risk-Managed Diversified Equity Income Fund
It should by now be fairly obvious that taking at least some sort of protective position may be advisable. One way that this could be accomplished is by taking a position in cash but considering that cash has no return in today’s low interest rate world, this is rather pointless. The Eaton Vance Risk-Managed Diversified Equity Income Fund offers another alternative that is reasonably safe and provides a very attractive 9.17% yield. According to the fund’s web page, ETJ has the stated objective of providing a current income and gains with a secondary objective of capital appreciation. Admittedly, this does not really mean that much as pretty much every equity fund says essentially the same thing. In practice, what this fund does is hold a portfolio of stocks that somewhat resembles the S&P 500 while using an options strategy to provide income and downside protection.
The fund basically uses an options collar strategy. A collar is where the options trader purchases a put and then sells a call with the same expiration date to pay for it. A collar is generally considered a neutral to bearish strategy since the put pays out if the underlying stock declines but the trader has to pay out if the underlying asset appreciates too far. The trader can keep the difference in premium if the underlying asset remains range-bound. In the case of this specific fund, the underlying asset on both the call and the put options is the S&P 500 index. The fund enters into short-dated options collars on a rolling basis. These collars will, therefore, prevent the fund from losing too much money if the index goes down but it also has the unfortunate effect of causing the fund to underperform in strong bull markets due to the call option effectively capping potential gains.
The use of these collars has a very expected effect on the share price of the fund. As we can see here, the stock price of the fund has remained almost flat over the past five years:
The share price has, in fact, returned 0.00% over the five-year period but over the time period, it remained remarkably range-bound, although there were two periods of volatility (late 2018 when everything went down over fears of rising interest rates and the start of the COVID-19 pandemic in the West when everyone was panicking and going to cash). This is somewhat misleading though since an investor that held the fund for the entire time would have actually made money when we factor in the distribution. Admittedly though, the total return here would have been less than what an investor in the S&P 500 would have received, which illustrated that this fund is very good for reducing the overall risks of your portfolio but it will not outperform in a strong bull market so it certainly should not be all of your portfolio.
The safest way to hold a collar is to actually own the underlying asset against which the collar is written. This is because if the call is triggered against the trader, then the asset is already there to deliver, saving the potential issues from having to buy it in the market and potentially taking a high loss. Thus, it may be surprising that ETJ does not actually own the S&P 500 index. Instead, as already mentioned, it owns a portfolio that somewhat resembles it. Here it is:
Source: Eaton Vance
We do see a number of large, widely held companies that are members of the S&P 500 index. In fact, as I pointed out in another article (linked earlier), many of these companies were responsible for essentially all of the positive performance that we have seen year-to-date. Thus, the underlying portfolio should perform at least somewhat comparably to the S&P 500 index, even if it is not exactly the same as the asset that the fund is writing call options on. Thus, the fund should still have minimal problems even if the call option half of the collar does get exercised against it.
These stocks and several of the others in the fund’s portfolio also have the effect of providing the fund with a source of dividend income. In fact, in 2019, (the latest date for which data is currently available), the fund received a total of $10,691,815 from dividends, which was more than enough to cover all of its expenses and still leave it with $4,207,192 in net investment income.
Based on our earlier discussion of the way that the fund’s option strategy works, it might be understandable to expect that it would deliver no to limited capital gains. This is, however, not the case. In 2019, the fund actually delivered $91,423,134 million in unrealized capital gains and $13,165,382 million in realized losses for a net gain of $78,257,752. When we combine this with the fund’s net investment income, it saw the actual value of its assets increase by $82,464,944 over the course of the year.
This should bring some degree of comfort to those investors that are worried about the classification of the fund’s distributions. As we can see here, the overwhelming majority of ETJ’s distributions are classified as return of capital:
Source: Fidelity Investments
The reason that this can be concerning is that return of capital is a distribution in excess of a fund’s net investment income and realized capital gains. Thus, it can be a sign that a fund is returning an investor’s own money back to them. This is obviously not sustainable over any sort of extended period. However, net investment income does not include unrealized capital gains. If a fund does distribute unrealized capital gains to investors, then it is classified as return of capital. Thus, this is simply a tax-efficient way to distribute the unrealized capital gains to investors. The fund distributed a total of $58,099,317 to its investors over the course of the year. Thus, it clearly made more than it actually distributed and there does not appear to be any reason for us to worry about the return of capital distributions.
We can see further evidence that the return of capital distributions is not harmful to the fund by looking at its net asset value over time. This chart shows both net asset value and the fund’s share price over time:
As we can clearly see, the fund’s share price and net asset value per share have generally been relatively range-bound over the past five years. Thus, we can conclude that despite some volatility, ETJ is generating enough value off of its investment portfolio to cover its distribution. Therefore, there does not really appear to be anything to worry about here with regard to the distribution.
As is always the case, it is critical that we do not overpay for any asset in our portfolio, especially funds that are designed to limit our risks in the event of a market decline like ETJ. This is because overpaying for any asset is a surefire way to ensure that we receive a sub-optimal return on our investment. In the case of a closed-end fund, the usual way to value it is by looking at a metric known as the net asset value. The net asset value of a fund is the current market of the fund’s holdings minus any outstanding debt. Therefore, it is the amount that the shareholders would receive if the fund were immediately shut down and liquidated. Ideally, we want to buy the fund when its shares are trading at a price that is less than net asset value because this means that we are obtaining the fund’s assets for less than they are actually worth. Unfortunately, that is not the case right now. As of November 6, 2020 (the most recent date for which data was available as of the time of writing), ETJ had a net asset value of $9.91 per share but the fund was actually trading for $9.98. This gives it a 0.7% premium to net asset value, which is not really too bad. While we would certainly prefer to get it at a discount, we could still consider the position here and view the slight premium as the price to pay for the protection that this fund offers.
In conclusion, the market is currently looking overvalued by a number of metrics. It might therefore be worth considering a way to protect yourself from possible future losses. ETJ appears to offer an even better way to do that right now than cash due to its substantially higher yield. The fund has been consistently been able to maintain its net asset value per share despite this distribution and the return of capital distributions, which any potential investor should find attractive. The fund does trade at a slight premium so it might be best to wait for a more attractive price but the premium is so small that we can view it as just the price to pay for the protection that this fund offers.
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Disclosure: I am/we are long ETJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.