~ by Snehasish Chaudhuri, MBA (Finance).
Eaton Vance Risk-Managed Diversified Equity Income Fund (NYSE:ETJ) is a closed-end equity mutual fund (“CEF”) that invests its $537.36 net assets in common stocks from diversified sectors of the U.S. market. In addition, it buys short-dated out-of-the-money, S&P 500 index put options and sells out-of-the-money S&P 500 Index call options of the same duration.
The primary investment objective is to provide current income and gains, with a secondary objective of capital appreciation. The fund has a high expense ratio of 1.1 percent, primarily due to its investments in put options. Otherwise, its turnover ratio of 55 percent is not excessively high. ETJ’s portfolio has a weighted average P/E ratio of 20.03, and this blend fund is currently trading at a decent discount of 3.36 percent.
ETJ is Successful in its Primary Objective of Generating Stable Current Income
Eaton Vance Risk-Managed Diversified Equity Income Fund was launched on July 31, 2007 by Eaton Vance Management. The same investment advisor manages the fund. ETJ benchmarks the performance of its portfolio against the S&P 500 Index and the Barclays U.S. Aggregate Bond Index. The fund generates monthly pay-off with a close to double-digit yield. Average yield generated during 2022 and 2023 are 10.04 percent and 10.35 percent respectively. Whereas average yield over the last 10 years has been 10.125 percent. ETJ has been successful in meeting its primary objective of providing stable current income, and thus suits the needs of income-seeking investors. However, the fund consistently failed to generate price growth until last year. Only during 2023, ETJ has been able to register price growth of 11.07 percent.
ETJ Top Investments Consists Mostly of Technology and Healthcare Stocks
Eaton Vance Risk-Managed Diversified Equity Income Fund invests almost 71 percent of its net assets in four high-growth potential sectors – industrial, healthcare, financial and information & communication technology (ICT). 18 out of ETJ’s top 30 investments are either in technology-oriented stocks like Microsoft Corporation (MSFT), Apple Inc. (AAPL), Amazon.com, Inc. (AMZN), Meta Platforms, Inc. (META), Mastercard Incorporated (MA), Alphabet Inc. Class C (GOOG), Accenture plc (ACN), NVIDIA Corporation (NVDA), Netflix, Inc. (NFLX), AMETEK, Inc. (AME), Salesforce, Inc. (CRM), Analog Devices, Inc. (ADI) and Uber Technologies, Inc. (UBER); or healthcare stocks like Eli Lilly & Company (LLY), AbbVie Inc. (ABBV), Bristol-Myers Squibb Company (BMY), Boston Scientific Corporation (BSX), and Zimmer Biomet Holdings, Inc. (ZBH). Together these 18 stocks account for almost half of ETJ’s entire portfolio.
2023 has been a great year for technology-oriented stocks. All those major technology stocks recorded strong price growth within a range of 13 to 219 percent. This has enabled Eaton Vance Risk-Managed Diversified Equity Income Fund to register a price growth of 11.36 percent. These stocks also registered strong price growth over the past five years. Barring UBER and NFLX, all other stocks grew by at least 7.5 percent CAGR.
The price performance of healthcare stocks was good too, although wasn’t as great as the tech stocks. Over the past one year, LLY, BSX and ZBH generated price growth in excess of 30 percent. Over the past five years, LLY, ABBV, and BSX grew in excess of 9 percent CAGR. Stock selection by ETG’s fund managers seems quite effective, and that enabled the fund to generate strong payouts.
ETJ’s Collar Option Strategy Did Work in Protecting it During the Bad Times
Eaton Vance Risk-Managed Diversified Equity Income Fund employs a collar option strategy, by which it sells out-of-the-money S&P 500 Index call options. Thus, the fund earns a premium. An out-of-the-money index call option has a strike price that is higher than the market price of the underlying index. In a bearish market, such options have little chance of being exercised. Thus, when the market failed to grow during the past three years, this fund was able to utilize the gains from those call premiums in order to distribute dividends. This covered call strategy is really helpful in a bearish market. However, there is a risk of losing huge money in case the stock price drops down significantly.
In order to safeguard itself, Eaton Vance Risk-Managed Diversified Equity Income Fund buys short-dated out-of-the-money, S&P 500 index put options of the same duration. An out-of-the-money index put option has a strike price that is lower than the spot price of the underlying index. As the put option is exercised when market price goes below the strike price, such options have a higher chance of being exercised in a bearish market. However, even if such options are not exercised, they work as a hedge to those out-of-the-money call options. This type of collar strategy is thus generally employed to reduce both positive and negative returns of an underlying asset in a volatile equity market.
Suppose ETJ has bought 1,000 GOOG which is currently trading at $80 per share. It purchases 1000 put options with a strike price of $70 at a premium of $2 and writes 1000 call options with a strike price of $90 on a premium of $4. So, initially, the fund gains a total of $2000. In case the market price reaches $100, ETJ will gain $20000 from stock, lose $10000 on exercise of call option and put option remains unexercised. Thus, ultimately ETJ will make a gain of $12000, instead of gaining $20000 if it was unhedged. If the market price drops to $60, ETJ will lose $20000 on stock and call option will not be exercised, and through exercise of put options, ETJ will gain $10000. So, the ultimate loss will be $8000, instead of $20000. In short, ETJ is able to save money under any circumstances, which enables it to offer a stable payout.
Investment Thesis
In an economic scenario involving high inflation and rising unemployment, a 10 percent yielding fund is a boon. The fund produced returns when stocks from technology and healthcare sectors were producing losses. However, that return was only in the form of yield, and the fund was generating negative price growth on a consistent basis. The best part of ETJ is that it has other means through which it can obtain the money that it needs to pay for its distribution. Fortunately, things have changed in favor of ETJ. During the past 1 year, especially in 2023, ETJ’s top investments in technology-oriented stocks and healthcare stocks generated strong price growth. In my opinion, this trend will continue as the stock selection of ETJ’s fund managers look impressive.
On the back of it, ETJ also was able to generate strong price growth. Thus, whatever doubt investors had over this fund has gone away. Moreover, this is perhaps the only fund that uses a collared options strategy. Eaton Vance Risk-Managed Diversified Equity Income Fund was one of the rare funds that was able to outperform the S&P 500 (SP500) last year, which indicates the fact that its collar option strategy did work in protecting it during a bad phase in the U.S. equity market. Under such circumstances, Eaton Vance Risk-Managed Diversified Equity Income Fund becomes lucrative for both income-seeking investors and growth-seeking investors. Since ETJ is available at a healthy discount, I’d prefer to accumulate some more units of this fund.
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