In February, an Eaton Vance equity income fund raised $5.5 billion, the largest initial public offering ever recorded by a closed-end fund. The crowds came clamoring in search of a rare commodity — yield. At a time when long Treasuries yield 4.8 percent, Eaton Vance Tax-Managed Global Diversified Equity Income pays about 9.4 percent. The fund achieves this rich return by using several yield enhancement techniques, including dividend capture and call writing.
While Eaton Vance has made the biggest splash, it is not alone in offering an equity fund that uses dividend capture and call writing to push yields north of 6 percent. Companies with open-end or closed-end funds in this category include Evergreen Investments, ING Group and Alpine Woods Investments. In recent years their funds have done quite nicely. But skeptics fear that the yields are too good to be true. What's the catch? Well, it takes a very skilled manager to achieve this kind of yield, and eventually, when the markets make an unexpected move, the manager's skill will be tested. “The high-yielding funds are attractive, but I am only putting up to 5 percent of a client's assets in the funds,” says Roger Nusbaum, chief investment officer of Your Source Financial, a registered investment advisor in Phoenix.
To appreciate the appeal of these funds, consider dividend capture, a strategy that has been used successfully for decades. Normally stocks pay dividends each quarter. To increase cash flow, an investor practicing dividend capture doesn't hold the shares for 12 months. Instead, he buys the stock just before the dividend will be paid — and sells right after the check arrives. The aim is to receive more than four checks a year.
Traditional practitioners of dividend capture were sophisticated investors; few funds tried the approach because it could generate big tax bills. Then in 2003, Congress cut taxes on stock dividends to a maximum of 15 percent. To qualify for the low rate, an investor had to hold the shares for 61 days. Now investors that had been collecting four dividends a year could suddenly collect six — and face no tax consequences. “The new law opened the door for dividend capture funds,” says Jill Evans, a portfolio manager of Alpine.
At the same time that dividend capture began gaining a following, yield-starved investors were also trying new call writing funds. In the simplest form of covered call writing, an investor who owns shares sells another investor the right to buy the stock in the future. With Citigroup shares at $54.09 in early May, an investor could receive $0.25 by selling the right to buy a share for $57.50 in June. Why bother with this trade? If the stock stays flat, the seller keeps the $0.25 in option premium and collects any normal dividends. The risk is that Citigroup shares will skyrocket to $60. Then the option seller will have to dispose of his stocks, losing the upside potential. Lately option-writing funds have been producing healthy results. A strong closed-end example is Nuveen Equity Premium Income, which currently yields 9.11 percent.
Together is Better
Some analysts advise holding both a call-writing fund and a dividend-capture specialist because each strategy has different weaknesses. Since it limits returns when stocks are rising, covered option selling does relatively poorly in roaring bull markets. For this same reason, covered call funds lost popularity during the 1990s stampede. But after the market downturn that began in 2000, investors discovered that extra yields could provide a nice cushion in flat or down markets, and option-writing funds began to gain more followers.
While covered-option writing typically thrives in down markets, dividend capture can run into trouble during market downturns. That's because stock prices typically drop after the dividend is paid. Say a manager buys a stock for $20 and receives a $2 dollar dividend. After the dividend payment occurs, the shares may drop to $18. In a bull market, the shares quickly recover and may move above the old high. But in a downturn, the shares rise slowly — or continue dropping. Consequently, an investor who buys just before the dividend payment is made could be left holding a falling stock. In recent years, dividend capture funds have faced few problems because stocks have been rising. Losses are usually overwhelmed by gains.
Eaton Vance Tax-Managed Global closed-end fund attracted record sales partly because it was one of the first closed-end funds to combine call writing and dividend capture. “By marrying the two approaches, you diversify the risks,” says Duncan W. Richardson, chief equity investment officer of Eaton Vance.
The Eaton Vance fund keeps about one third of assets in covered calls. Some of the remaining assets are traded in dividend capture strategies. In addition, the fund buys and holds some high-quality dividend-paying stocks. The long-term holdings help the fund benefit from bull markets and prove reasonably resilient in downturns.
Across the Pond
Investors who prefer sticking with option writing should consider ING Global Equity Dividend Premium, a closed-end fund that yields 8.9 percent. The fund buys and holds blue chips from around the world, including Citigroup and Telecom Italia. Option writing provides some extra juice. European stocks can be particularly tempting because they often pay higher dividends than their counterparts in the U.S., says ING senior vice president Paul Zemsky. European investors have long focused on dividends, and companies have obliged with higher payouts, says Zemsky. “There are many European companies that yield 4 percent,” says Zemsky. “That's more than twice what you can get in the U.S.”
For a fund with dividend capture, consider open-end Alpine Dynamic Dividend. The fund buys a stock before the dividend payment and typically holds for about 90 days. While one third of the portfolio is in dividend capture strategies, the rest is in long-term holdings of dividend paying stocks. The aim is to provide some capital appreciation along with yield. “Clients may say that they just want income,” says Alpine portfolio manager Jill Evans. “But if you give them only income and not capital gains, they are disappointed.”
Open-end Evergreen Utility & Telecommunications keeps most of its assets in the U.S., but performs dividend capture strategies mainly in Europe. Many European utilities pay dividends once a year, says Evergreen portfolio manager Tim O'Brien. “If you focus on European stocks, you can pick up a full year's income with one trade,” says O'Brien.
RELIEF FOR YIELD-STARVED INVESTORS: COVERED CALL WRITING AND DIVIDEND CAPTURE FUNDS.
|Eaton Vance Tax-Managed Global Diversified Equity Income||ETY||Equity Income||9.02%||-0.29%|
|ING Global Equity Dividend Premium||IGD||Global Equity||8.9%||2.78|
|Nuveen Equity Premium Income||JPZ||Equity Income||9.1%||-0.58|
|Source: ETF Connect. Data through 5/4/07.|
|Fund name||Ticker||Category||Yield return||1-year return||3-year|
|Alpine Dynamic Dividend||ADVDX||Mid Value||13.4%||17.3%||16.4%|
|Evergreen Utility & Telecommunications A||EVVAX||Utilities||6.4||35.1||27.9|
|Source: Morningstar. Data through 3/31/07.|