Last summer I covered BlackRock’s Enhanced Equity Dividend Trust (BDJ) in the article “Defensive Alpha With The BlackRock Enhanced Equity Dividend Fund.” I found that the fund had a general track record of outperformance compared to other high dividend funds and generally outperformed the most during more volatile periods.
As I mentioned in the article, we were in a late-cycle period last year and now it seems we are at the end of the economic cycle. While I remain bullish on individual companies, I am bearish on the market as a whole. As such, many are likely looking to funds like BDJ as areas where more defensive performance is feasible.
That said, the fund did underperform the S&P 500 during the recent sell-off. This was exaggerated since it fell to a significant discount to NAV, but it underperformed even on a NAV basis. See below:
This will likely cause some investors to be uncertain about the fund’s defensive nature. The pronounced sell-off of BDJ is largely attributable to its option selling position. 53% of the fund is in covered call options and call premiums have been abysmally low.
On top of that, BDJ’s current sector exposure is generally value-oriented with high exposure to financials. Importantly, financials saw the most significant declines in March as many investors fled 2008’s “risk assets.” Let’s dive deeper to see if this underperformance is likely to continue.
A Lack of Demand for Call Options
One of the most significant problems with the fund is that it generates a yield by selling call options. This is generally fine, but call option selling has become so popular and demand for calls has been poor. This leads to underperformance of the strategy.
As you can see below, before the crash the VIX (which measures SPX option premiums) was generally low. Further, the put/call ratio shows call option demand has been far lower than put option demand:
When demand for call options is low, covered call sellers are unlikely to generate a high return. In fact, call premiums have been so low that most covered call strategies have chronically underperformed in recent years.
The rise of covered call strategies is somewhat problematic for BDJ. The investment world has shifted toward income and away from growth, causing a significant rise in popularity of call-selling strategies that usually deliver extremely high dividend returns. BDJ with its 8.5% dividend yield is an example. Problematically, if people are systematically selling calls then they are capping their potential gains for low premiums, leading to underperformance.
Further, short-selling has been a highly unpopular strategy. While some market participants buy calls for speculative or complex purposes, their main use is to hedge short positions. As you can see below, a relatively low portion of S&P 500 open interest is currently short:
The same was generally true for the highest-weighted stocks in BDJ up until around six months ago:
If the market remains at a higher level of volatility, demand for call options will likely rise and so too will premiums. Ideally, this will buffer losses for BDJ.
This situation is not dissimilar to that of 2008. Back then, BDJ began as an underperformer compared to most, but it along with an explicit call-selling fund (PBP) eventually outperformed by 10%+:
This came as call premiums rose during the sell-off due to higher volatility and higher demand from short-sellers.
Now, it should be pointed out that BDJ’s strategy is not that defensive. It is likely to outperform and, over the long run, has been able to deliver returns in excess of what would be expected. That said, it is still generally expected to perform with the market. Further, if dividend returns are not reinvested, the principal will likely fall toward zero due to upside caps.
A Look at BDJ’s Current Sector Exposure
While option selling is important for BDJ’s dividend yield and defensive outperformance, BDJ’s true alpha stems largely from its value-oriented sector exposure. As you can see below, the fund is highly weighted toward Financials, Healthcare and Technology:
This is quite different from the S&P 500’s current exposure, which is weighted firstly to technology (25%) then healthcare (15%) and then financials (11%).
Importantly, financials trade at much lower valuations and usually have higher dividend yields than technology or healthcare. The financials ETF (XLF) currently has a low weighted-average forward “P/E” of 13X while the technology ETF (XLK) is higher at 22X.
Financials carry a heavy burden after their near-collapse in 2008. Investors have given them chronically lower valuations and generally higher option premiums. In my opinion, financials are actually among the least risky sectors today due to their greatly enhanced capitalization and immense central bank/government support. As one of many examples, consider banks are given a large 5% commission on guaranteed COVID-PPP SBA loans.
Due to government protection and low valuations, I believe the financial sector is likely to be a consistent outperformer this year and years ahead. Most of what I like about banks does not exist for technology stocks. Technology stocks have high valuations and are facing increased regulatory criticism from the government. Thus, I expect technology to become an underperforming sector. Due to this, BDJ is likely to deliver excess alpha to the technology-heavy S&P 500.
The Bottom Line
Overall, I do not expect BDJ to deliver positive performance over the next six months. However, I do believe that it is a generally better place to put equity exposure than the S&P 500 and perhaps most other equity funds. As call premiums rise during periods of high volatility, the half of the fund dedicated to call option writing is likely to outperform via higher dividends. Over the long run, its strong value-oriented sector exposure is likely to enhance excess returns.
Importantly, because it is actively managed, BDJ does have a higher management fee of 80 bps. However, as mentioned in my previous article, it tends to earn its keep via alpha. Additionally, if you are looking to buy the CEF, it is currently trading at an enticing 9% discount to its net asset value:
Overall, I am neutral to bearish on the fund over the next few months, but I believe it will outperform the S&P 500 regardless of direction.
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