A Buy-Write Tech Fund for High Yield

06/02/2017 2:52 am EST

Focus: FUNDS

Carla Pasternak

Editor, The Income Investor

Tech stocks are on a roll and the technology-rich Nasdaq Composite has also been breaking new records and is now trading at its highest level ever, notes Dr. Carla Pasternak, income specialist at Dow Theory Letters.

These gains are not new. Information Technology has been the top performer of all 11 S&P 500 sectors for the past three years. Nor can the gains simply be chalked up to irrational exuberance.

At 18 times trailing earnings, the sector is not overvalued compared to the S&P 500's PE of 24 times. And going forward, earnings momentum should keep the rally going strong.

CFRA Research expects the S&P 500 Technology sector to post the strongest growth of all sectors, with an estimated 16.5% rise in this year's first quarter compared to 9.9% growth for the S&P 500.

Going forward, Trump's proposed overhaul of the tax system bodes well for the sector. Specifically, if the tax holiday on repatriating foreign cash passes Congress, tech could get a boost. 

If these tech giants brought their cash hoards back home, they could finance mergers and acquisitions, as well as ratchet up their research and development, buy back shares, and increase dividends. The repatriated cash would benefit the industry, shareholders, and the broader economy.

In sum, the pieces are in place for the technology sector to continue thriving. For really juicy yields in the tech sector, you need to turn to an actively managed closed-end fund (CEF) that writes options on tech stocks. The options strategy can be risky, but in a favorable environment for the sector, the rewards can outweigh the risk.

Closed-end fund Eaton Vance Tax Managed Buy-Write Opportunities Fund (ETV), which offers an enormous yield of nearly 9%. The fund invests in a portfolio of stocks that track the S&P 500 and the NASDAQ  100 Index.

With its focus on providing income, the fund follows a conservative options writing strategy. The conservative approach is to sell options with a low probability of being called because they are "out of the money," meaning their strike price is well above the current index value.

To compensate for the reduced risk of the option being exercised, this approach attracts a lower premium than a more aggressive "in the money" strategy. The net effect of a conservative "buy-write" strategy is to collect premiums, while limiting capital gains potential but also protecting losses.

The fund's name also refers to "tax managed" income. The fund follows a "managed" dividend policy by doling out distributions at the same rate each month, regardless of whether earnings are higher or lower that month.

Option income from premiums is variable and generally does not qualify for the reduced dividend tax rate. But in an effort to soften the tax consequences, the fund treats the distributions as "return of capital." The fund can treat the distribution as return of capital, for example, by selling portfolio securities at a loss to offset unrealized gains on positions that have appreciated.

The benefit of this type of distribution is that it is not taxable when received. Instead, the income reduces the cost base when the shares are sold and subject to a reduced 15% capital gains tax.

The monthly distribution of $0.1108 per share has remained at the same rate for the past five years. That equates to a hefty annual distribution yield of 8.5% of the fund's current price ($1.33/$15.62).

Year-to-date, most of the distribution consisted of return of capital. An annual management fee of 1.09% of net assets slightly reduces returns.

As a closed-end fund, ETV trades at a discount or premium to its net asset value.  The shares have traded at a 52-week average premium of 6.09% and are currently trading slightly above that at 7.27%, meaning they are reasonably valued relative to their historical norm.

Year-to-date returns of 8% underperformed the buy-write category and are about half of Nasdaq 100 returns but on par with the S&P 500.

Longer term, however, 3-year annualized average returns of 12% place ETV in the top 10% of its category and ahead of the S&P 500. While ETV's 3-year returns are still less than the 17% for the Nasdaq 100, they are also half as volatile.

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