ETJ: Equity Collar CEF, Needs Re-Tooling (NYSE:ETJ)

Thesis

Eaton Vance Risk-Managed Diversified Equity Income Fund (NYSE:ETJ) is an equity collar closed end fund. The Fund has current income as its primary objective and invests in a portfolio of common stocks with an equity collar option overlay. An equity collar represents an options strategy where the fund sells out-of-the-money calls and buys out-of-the-money puts and is supposed to dampen any downward moves in a bear market. ETJ has 67 holdings that try to replicate the S&P 500 performance, with the options structure layered on top.

From that perspective ETJ is supposed to be a vehicle that is safer than an outright index position during a bear market. However, in 2022 ETJ’s total return performance is worse than the S&P 500!

In this article we are going to do a deep dive into the mechanics of today’s bear market and the structural issues associated with the ETJ’s collar overlay.

Structural Issues with ETJ’s Equity Collar

An equity collar represents an options strategy where the fund sells out-of-the-money calls and buys out-of-the-money puts, usually for a zero-cost, depending on the option skew. What does this do, and please spell in out in English you might ask. Simply put, the fund sells most of the upside of the stock portfolio, while at the same time protects the downside performance via the rolling puts:

We can see from the above table a number of facts:

• the fund has only 67 holdings
• the fund has sold calls on 93% of the portfolio
• the fund has bought puts on 93% of the portfolio
• the calls are 12.2% out of the money, while the puts are 0.8% out of the money

Basically the fund is very defensive currently, with any portfolio losses greater than 0.8% being covered by the puts, while the upside is left with a nice buffer of 12.2% if the underlying equities portfolio rallies. Please note that the portfolio managers have the ability to change the “% Out of the Money” for both puts and options, and actively do so as part of their active management. However, the fund keeps systematically using only a 2-window time-frame for their rolling collars (in the above table we can see a 16-day average expiration period for the options).

This static 2-week average expiration period is problematic for a bear market like the one experienced today:

This year’s bear market has been marked by a volatile “wave” pattern – i.e. the move down has not been a slow orderly grind, but violent downswings have been followed by lengthy bear market rallies. What does this mean for ETJ? It means that the classic, short-rolling collar structure does not work that well. We have seen the fund adjust, by narrowing the put levels and widening the upside in the calls (for a price – since it will not be zero cost anymore):

We can see that around the same time last year the fund’s collar structure was different, with less upside left for the call options. So the fund management has correctly adjusted for bear market rallies. Versus 2021, the fund management now leaves more upside via their written call options, which correctly accounts for the bear market rallies. However, this does not come for free:

We have modelled above a 2-week collar for the SPY with the same characteristics as the ones ETJ currently exhibits: the written call is built around 12% out-of-the-money-ness, while the purchased put is at around 1% out of the money. We can see that the associated cost for this structure currently is enormous – $4.27 for each contract! Basically if the SPY does not move or goes upwards just a little, the fund loses around 1.12% every 2 weeks from this structure. The reason for this is the high implied volatility in options right now and the skew to the downside – everybody and their mother is buying puts!

Ultimately what we do not like here is the 2 week structure – if the fund had done a 1-year equity collar at the beginning of the year it would have had a tremendous performance in 2022. The short-dated collar does not work in a bear market like today’s where you grind down for a while and then you have long bear market rallies.

ETJ Performance

2022 has been a very ugly year for ETJ:

The CEF has managed to “outperform” the S&P 500 to the downside in 2022. That is unheard of for this fund, and the complete opposite for why an investor would buy shares here. Until this year the fund had a very shallow drawdown profile during the other downturns:

We can see from the above table that prior to this year, the fund never had drawdowns exceeding -15% during the past downturns. Not even during Covid. The reason behind that performance is the set-up. Violent and unilateral moves to the downside are beneficial to the fund because the put option kicks in. Prolonged bear markets, with a wave pattern, are toxic for the fund since the collar structure becomes more and more expensive (in the current set-up) and the put protection is not always there due to the 2-week framework.

Ultimately, the 2-week rolling equity collar structure does not work in a slow, prolonged bear market like this one.

Conclusion

ETJ is an equity collar CEF. The fund has an equities portfolio that mimics the S&P 500 and overlays it with an options collar structure. The strategy writes covered calls while at the same time purchases puts to manage the downside. Historically the equity collar overlay has resulted in very shallow drawdowns during past downturns. The reason was the speed and shape of the downturn – most of them being short lived and exposing continuous down moves. In today’s long bear market, which has been punctuated by months-long bear market rallies, ETJ’s 2-week rolling collar overlay underperforms. The fund is down more than the S&P 500 in 2022, exhibiting a shocking performance for a fund that is supposed to be hedged. The reason behind this performance is the expensive cost structure for the put options in today’s environment, and the 2-week systematic roll strategy. ETJ for example, would have had a much better performance if it had done a 1-year collar at the beginning of 2022 (it could have had only a -5% drawdown in that instance for example). We expect more of the same – this bear market will not end until mid-2023, and ETJ is losing a tremendous amount of cash via the 2-week collar strategy. The fund needs a re-tooling to make it more efficient for this prolonged bear market and is to be avoided until then.