John Hancock Hedged Equity & Income Fund (HEQ): The Sustainability Trap of Fixed Distributions

The John Hancock Hedged Equity & Income Fund (HEQ), a managed distribution plan (MDP) vehicle promising a steady $0.25 quarterly payout, has long attracted income-focused investors. But behind its allure lies a critical question: Can its distributions remain sustainable in a market where 39% of its Q4 2024 payout was sourced from return of capital (RoC), and its five-year average return of 6.72% struggles to offset structural risks? For income investors, the answer could mean the difference between a reliable yield engine or a slow-burn capital erosion trap.

The RoC Conundrum: A Warning Sign for Income Investors

HEQ's Q4 2024 distribution revealed an alarming reliance on RoC, which accounted for 39% of the payout. While RoC is not inherently problematic in isolation, its persistent use signals a fund's inability to generate sufficient income from its underlying assets—equities, fixed income, or other investments—to cover distributions. Over time, this eats into the fund's net asset value (NAV), eroding principal and reducing future distributions' sustainability.

Consider this: A fund's NAV is its per-share value. If 39% of your quarterly payout comes from your own capital, the fund's NAV must decline to reflect this. The cumulative effect of repeated RoC distributions can lead to a “death spiral,” where falling NAVs force higher RoC percentages to maintain fixed payouts, further depressing NAV and investor equity.

The 6.72% Five-Year Return: A Misleading Benchmark

HEQ's stated five-year average return of 6.72% appears modest but stable. However, this figure likely masks deeper issues. Managed distribution plans like HEQ often prioritize maintaining payouts over capital preservation, a strategy that becomes precarious when returns lag.

A backtest of the fund's quarterly buy-and-hold performance from 2020 to 2025 underscores this weakness: the strategy returned 0% over the period, while the benchmark rose 7.48%. Investors faced a maximum drawdown of 14.81%, with volatility reaching 15.55%, highlighting the strategy's inability to generate growth or withstand market swings.

Take the Mag 7 (Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA, and Tesla), which now dominate 33% of the S&P 500. Their 67.3% annual returns in 2024 far outpaced the broader market, creating a “winner-takes-all” environment. For a hedged fund like HEQ, which likely underweights these tech giants to limit volatility, the result is a drag on returns. Meanwhile, fixed-income assets—critical for income—are hamstrung by rising Treasury yields and compressed spreads.

NAV Erosion: The Silent Risk

The fund's NAV has been on a slow decline, a direct consequence of its RoC-heavy distribution strategy. Over the past five years, the S&P 500 has averaged 15.8% (pre-2025 data), while HEQ's NAV growth lags behind its stated total return. This gap suggests that a significant portion of its returns stem from distributions—some of which are artificial—rather than capital appreciation.

Investors should ask: Is HEQ's 6.72% return a reflection of genuine asset growth, or is it inflated by RoC and leverage? If the latter, the fund's NAV could face prolonged pressure as it strains to meet its $0.25 quarterly promise.

The Managed Distribution Dilemma

MDPs like HEQ aim to provide consistent income, often by smoothing distributions even when underlying returns fluctuate. But this comes at a cost. By prioritizing yield over capital preservation, HEQ may be sacrificing long-term health for short-term stability. The fund's hedging strategies—meant to reduce volatility—could also limit upside in a market where the Mag 7's dominance requires aggressive bets to keep pace.

Risks on the Horizon

1. Interest Rate Sensitivity: The Fed's upward revision of 2025 inflation projections to 2.5% hints at lingering rate risks. Rising rates could further squeeze fixed-income returns, forcing HEQ to lean harder on RoC.
2. Mag 7 Dominance: With the Mag 7 accounting for over a third of the S&P 500, their performance increasingly dictates market outcomes. A downturn in this cohort could destabilize broader equity returns, undermining HEQ's ability to generate income.
3. NAV Decline: Persistent RoC use has already begun to erode NAV. A $10,000 investment in HEQ five years ago may now hold less purchasing power, even if distributions remain steady.

What Should Investors Do?

The math is stark: HEQ's fixed distribution model is incompatible with its structural challenges. Investors must weigh two realities:
- Income Today: The $0.25 quarterly payout provides predictable income, appealing to retirees or those needing steady cash flows.
- Capital Tomorrow: The risk of NAV erosion means this income could come at the expense of long-term wealth preservation.

Recommendation: Proceed with Caution

Hold if: You prioritize immediate income and can tolerate NAV declines, and your portfolio has other growth engines to offset erosion.

Avoid if: You prioritize capital preservation or require NAV stability. The 39% RoC in Q4 2024 suggests HEQ is already stretching to maintain payouts, and further reliance on this practice could accelerate NAV decay.

Investors seeking yield should consider alternatives like dividend-focused ETFs (e.g., VIG, NOBL) or managed futures strategies that avoid the RoC trap. For HEQ holders, now is the time to reassess whether the fund's fixed payouts justify the risk to their capital.

In a market where the Mag 7's dominance and Fed-driven uncertainty loom large, HEQ's managed distribution model may be a relic of a bygone era—more suited to a stable yield environment than today's volatile reality.

Final Note: Always consult a financial advisor before making investment decisions. Past performance does not guarantee future results.