JEPI - JEPI: Equity Dividend Yield On Steroids

2023-08-21 10:52:19 ET

Summary

• JEPI offers a higher yield compared to the S&P 500 and other income-focused ETFs.
• I like JEPI's defensive asset allocation with lower volatility and higher earnings growth than the S&P 500.
• Selling volatility through options helps JEPI generate very attractive income, benefitting from market volatility.

As of 20th August 2023, the U.S. 10 year treasury yield trades at approximately 4.25%, as compared to a dividend yield of ~1.5-1.6% for the S&P 500 (SP500). Moreover, even income-focused ETFs such as the popular Schwab U.S. Dividend Equity ETF ( SCHD ) currently fail to deliver a treasury-competitive yield.

The JPMorgan Equity Premium Income ETF (JEPI) is special in the world of equities, as the fund aims to generate income through dividends, while selling equity-linked notes on the portfolio. In that context, selling equity-linked notes can be best understood as writing call options on the S&P benchmark, thereby reducing portfolio delta and collecting a premium. If historical performance is a guide for future expectations, then investors may reasonably expect that the JEPI portfolio strategy will deliver a 9-11% annual income, while protecting the notional capital base.

With that frame of reference, although the below chart is a bit outdated, the graphic still gives a good comparison of JEPI's distributable income vs. major asset classes, highlighting a highly attractive value proposition of JEPI for dividend-focused investors.

Overall, I continue to rate JEPI a "Strong Buy". In line with my initiation coverage in October 2022, I continue to like JEPI's low-beta and short-duration investment strategy, which leverages equity volatility to generate returns. In that context, investors should take note of the renewed, gradually upticking VIX, as well as a net "Short Gamma" positioning of option dealers and traders for the first time in 2023.

Defensive Portfolio Asset Allocation

The first argument I would like to highlight in context of why JEPI is such a great option for income-focused investors is related to the fund's defensive asset allocation: As compared to the S&P 500, with the 1x Beta benchmark, JEPI's 1-year Beta is only 0.64; respectively, versus the S&P 500's 19% 1-year return standard deviation, JEPI's comparable metric is only 13.3%. In line with the lower portfolio volatility, JEPI demands a P/E premium vs. the S&P 500; however, the premium is very manageable with only 20.5x P/E vs. 19.7x for the S&P 500.

Comparing JEPI against the S&P 500, there is one additional data point that I would like to highlight, which is growth. Referencing JEPI's low portfolio volatility vs. the S&P 500, an investor would likely expect that the growth in JEPI's underlyings is low. But this is not the case: For the trailing twelve months, JEPI's EPS growth on a portfolio level was 10.5%, as compared to only 9.9% for the S&P 500.

To sum it up, against the S&P 500, JEPI offers investors (i) lower portfolio Beta, (ii) lower portfolio volatility and (iii) higher earnings growth, while demanding only a slightly more expensive P/E.

To achieve JEPI's low portfolio volatility levels, the fund anchors on a well-diversified asset allocation approach, paired with bottom-up fundamental research on single company. On a sector level: about 13% is invested in Information Technology, 12.9% is in Financials, 12.1% is in Health Care, 11.5% is in Industrials, and about 11.2% is in Consumer Staples -- with the remainder balanced on other sectors. On a more granular level, investors will note that no single name stock touches the 2% benchmark. And the allocation difference of the portfolio's top 1 holding vs. the top 10 holding (all blue chip companies) is only 27 basis points.

Volatility - The Income Steroid

Paired with a strong equity selection process, the strategy of selling volatility to hedge portfolio Delta while collecting an option-premium fee is what makes JEPI so special. Or as communicated by the fact sheet:

[JEPI] generates income through a combination of selling options and investing in U.S. large cap stocks, seeking to deliver a monthly income stream from associated option premiums and stock dividends

Accordingly, the higher the market volatility, the higher the VIX/ implied volatility expectations, and the higher the call writing premium for JEPI. So, while most equity investors fear and hate volatility, JEPI owners thrive on it.

With that frame of reference, the CBOE Volatility Index serves as a tool for assessing investors' anticipations regarding the level of volatility in the equities market over 30-day span. To put it more pragmatically, when there is a surge in the VIX, it signals an increase in uncertainty and likely market turmoil; while a contracting VIX signals just the opposite.

Talking about the VIX, it's worth highlighting that the VIX has been consistently decreasing year-to-date, with a likely low in early summer of 2023. Notably, the duration of this declining trend in the VIX coincided with a consistent upward trend in the value of equities. Now, however, volatility is slowly picking up -- benefitting JEPI's overwrite strategy.

In a recent article on the VIX, I have given insight that option dealers and traders are now "Short" on Gamma for the first time in 2023. While a more detailed explanation on Gamma can be found here, the key takeaway that investors should consider is that "Short" Gamma positions can provoke a "volatility feedback", contributing to expanding market volatility.

Risks

Generally speaking, JEPI reduces investor risk through selling option premium. That said, however, there are two major risk considerations that I would like to highlight and briefly discuss. First, it's important for investors to know that the JPMorgan Equity Premium Income ETF is an equities fund. Accordingly, even though the asset allocation is defensive, the ETF's performance might still be affected by (typical) sudden stock prices fluctuations. Second, if an investor is focusing more on growth, and less on income, then JEPI might not be the best choice. I see two main reasons for it: A) The ETF limits how much it can gain when the stock market is doing really well, because the "Short volatility" strategy sells upside through writing call options; B) The ETF puts money into stocks that tend to be more stable and do better when the economy isn't doing so great. Thus, in a very bullish market, JEPI's defensive strategy may likely underperform the S&P 500.

Strong Buy

The JPMorgan Equity Premium Income ETF outshines income-focused ETFs such as the SCHD; and even outshines the 10-year treasury yield. Reflecting on the current macro-environment, which points to a likely pick-up in volatility for the remainder of 2023, I like JEPI's low-beta and short-duration investment strategy, which actually benefits from volatility expansion.

On the backdrop of JEPI's call-overwrite strategy, I would expect to receive a 9-11% annual income yield from the fund, with little downside (but also upside) to the capital base. Investors might also appreciate that the JEPI is a relatively low-cost ETF, with net expenses as low as 0.35% per year.

Overall, I rate JEPI a "Strong Buy".

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