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 (NYSE: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:
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:
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…
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