Hazardous Advice—Reaching for Yield

Hazardous Advice - watch out!

Acting on generic investment advice in magazines—or on the internet—can be hazardous to your wealth.

In their desire to attract readers, publications often fail to fully explain an investment or adequately disclose the risks.

The other day I ran across a particularly worrisome article on Forbes.com with the title “The Amazing 8.8% Cash Payout No One’s Talking About.” The article highlights two funds that primarily invest in technology companies, but pay a high dividend yield.

The title refers to the Eaton Vance Tax-Managed Buy-Write Opportunities Fund (ETV).
Quoting the article:

“Try the Eaton Vance Tax-Managed Buy-Write Opportunities Fund, whose top 25 holdings are mostly made up of tech and biopharma stocks (Apple is its No. 1 investment). This fund pays a more generous 8.8% dividend yield, but you will pay a price for that payout: long-term performance.

While ETV’s return is close to that of the S&P 500, it’s behind the tech sector as a whole. There are a couple reasons for this: first, ETV has focused on other areas besides tech. Second, its bigger cash payouts mean it keeps less money to reinvest, so compound returns aren’t as great.”

This simplistic description presents a number of problems.

First of all, the article never explains how the fund can possibly pay such a high dividend—it doesn’t even allude to what makes the fund unique. What is a “buy-write opportunity” fund?

Secondly, it mentions that the long-term performance lags the tech sector, but doesn’t mention the asymmetric risk created by the fund’s “buy-write” investment approach—which is likely also a major contributor to its long-term performance trailing tech as a whole.

So what does this fund actually invest in?

Quoting the fund’s fact sheet: “The Fund invests in a diversified portfolio of common stocks and writes call options on one or more U.S. indices on a substantial portion of the value of its common stock portfolio to generate current earnings from the option premium.”

What this means is:

  • The fund invests in a large number of different companies. The fund is over-weighted in the technology sector (39% of value as of Q4 2017)—but it has diversified holdings across 181 equities (not just tech and biopharma).
  • It “writes” (i.e., sells) call options against various U.S. indices (e.g., S&P 500 index). A call option is the right—but not the obligation—to buy an asset in the future at a pre-determined price. This means that the fund collects money (i.e., the option premium) for granting the right to someone else to buy an index at a later date for a fixed price. Hence, if the market goes up, the other party will exercise their call option for a profit—and the fund will take a loss on the option.
  • Since we don’t know which indices they are writing call options against, or at what strike price, it is impossible to know the exact risk profile. But the gist is that the fund has sold off a portion of the upside from the stock holdings in exchange for generating current income via the option premiums.
  • The net result is likely that the fund will not increase as fast as the overall market when prices are increasing, but retains all downside risk when stock prices are declining (i.e., an asymmetric risk profile), while in exchange generating some level of income from the option premiums.

Wait, there’s more

But that is not the bad part. It’s debatable whether this is a good investment strategy or not, but I have a different issue with the article’s description of this fund. Forbes implies that the fund is able to generate an 8.8% annual dividend by employing this investment strategy.

A quick look at the fund’s disclosures demonstrates that this is not the case. The fund is designed to pay out a high level of income via a “managed distribution plan.” This means the fund returns a fixed amount of money per share every month—it has distributed $1.33 per share annually for each of the past 7 years—regardless of the income generated from stock dividends, capital gains, and the option premiums.

But how? The fund uses what is called a “return of capital” distribution. Meaning the fund gives you back a portion of the money (i.e., capital) you invested—they are just giving you back your own money. For 2017, 93% of the total distribution to shareholders was a return of capital. Applying this to the 8.8% yield the article touts, fund results generated about 0.6% yield and returned 8.2% of the investor’s own money.

This may be an acceptable strategy for investors needing a steady income stream to cover living expenses, but should not be confused with an investment actually generating an 8.8% return. Another reminder that, if somethings seems too good to be true—it probably is.

NOTE ON TERMINOLOGY: the “yield” on a mutual fund or ETF is not necessarily the same thing as the “dividend yield” from a stock. What is sometimes referred to as the “mutual fund yield” or “distribution rate” on a mutual fund or ETF is the total amount of money paid out to each shareholder divided by the per share price—regardless of where the money is coming from (as this example demonstrates). Whereas, the “dividend yield” on a stock is the actual dividend income generated divided by the share price. The use of the term “dividend yield” in the Forbes article in reference to the ETV fund’s payout is misleading.

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