JPMorgan JEPI ETF: Forget capital gains, focus on high income

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The JPMorgan Equity Premium Income ETF (NYSEARCA:JEPI) offers investors exposure to large-cap US stocks, but with a significantly higher dividend yield, driven primarily by option premium generation, currently at nearly 11%. Focused for the US Investors will most likely outperform this ETF given the weak returns implied by current S&P500 ratings. JEPI is an actively managed income-based equity ETF that holds derivatives and is therefore more risky than regular long-only ETFs. Also, since the ETF has only been around for two years, there is limited historical data to test how it performs in different market conditions. All in all, however, I think the fund is a buy, particularly for those looking to reduce volatility in their portfolio.

The JEPI ETF

The ETF aims to provide the majority of the returns associated with the fund’s primary benchmark, the S&P500, while exposing investors to less risk through lower volatility, while still providing high returns. The ETF does this by creating a portfolio of stocks with lower volatility than the S&P500 and also investing in equity-linked notes (ELNs). Under normal circumstances, the fund invests at least 80% of its assets in equity securities, while ELNs make up up to 20% of the portfolio and generate premium from selling call options. JEPI therefore employs a similar strategy to XYLD, which I covered last month (see “XYLD: A Straightforward Alternative to SPX”), and the two ETFs have performed very similarly since JEPI’s inception in June 2020.

Return of JEPI vs. XYLD

JEPI vs. XYLD, Total Return (Bloomberg)

The main difference is that the JEPI employs an actively managed strategy, with fund managers using a bottom-up research process with stock selection based on our own risk-adjusted stock rankings. This is another attractive feature of the ETF compared to the XYLD, as it means less exposure to expensive market segments like technology, as well as less concentration risk, as the top 10 securities make up just 18% of total holdings compared to 27%. for the XYLD. Additionally, JEPI has a slightly lower expense ratio of 0.35% versus XYLD’s 0.6%.

JEPI ETF Top industry holdings

JEPI Top Industry Holdings (Bloomberg)

XYLD Top stocks in the industry

XYLD Top Industry Holdings (Bloomberg)

Why the JEPI strategy is now attractive

I particularly like the strategy of selling call options to gain income in the current market where US equities are overvalued. As I argued in yesterday’s “SPX: Dip Buyers Beware,” still-extreme valuations keep the S&P500 priced in for negative total returns for years to come, and the 1.6% dividend yield is too low to offset the risk of losing capital . The main disadvantage of JEPI and other stock income ETFs is that they underperform during bull markets. However, as we have seen over the past few months, the high yields allow them to outperform during periods of weak equity markets.

S&P 500 Rating vs. Subsequent Returns

S&P500 Rating vs. Later Returns (Bloomberg)

The ETF’s current 30-day SEC return, which is generated by combining dividends on its stock holdings and option premium income, is a whopping 10.7%, over 9pp higher than the S&P500 itself. Thus, the JEPI underperforms the S&P500 performs, the latter would need to continue generating returns well in excess of economic growth, which features nominal GDP and revenue growth of around 4%. This means that valuations for the S&P500 would have to rise further from the current extremes for the index to outperform the JEPI. Even if that were the case, JEPI’s stock holdings would also likely rise sharply, allowing the fund to generate strong returns.

Risks to consider

The fund’s actively managed nature and use of ELNs means that there are additional risks associated with the JEPI compared to the S&P500. There is no guarantee that the fund managers will be able to select stocks with lower volatility than the S&P500, and the fact that the ETF’s stock holdings differ significantly from the S&P500 means that it will lag significantly behind itss in the near term Benchmark could lag behind.

However, perhaps the greatest risk lies in the use of derivatives. As explained in the ETF’s prospectus, if the price of the underlying instruments unexpectedly moves, the Fund may not achieve the expected benefits of an investment in an ELN and may suffer significant losses, which could include the Fund’s entire investment. Investments in ELNs are also subject to liquidity risk, which can make them difficult to sell and value. A lack of liquidity can also cause the value of the ELN to fall. Additionally, ELNs may exhibit price behavior that is uncorrelated to the underlying securities. The Fund’s ELN investments are subject to the risk that issuers and/or counterparties will fail to make payments when due or will default entirely. The prices of the Fund’s ELN investments may be adversely affected if any of the issuers or counterparties in which it invests experience actual or perceived deterioration in its credit quality.

The fact that the ETF has only been in existence for two years also means that there isn’t a great track record to gauge how the fund performs in adverse credit market conditions like the ones we saw during the global financial crisis. For these reasons, I would recommend investors to hold JEPI as part of a more broadly diversified portfolio. Nonetheless, from a risk-reward perspective, the ETF seems to be outperforming, especially for US-focused investors.

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