JEPQ - JEPI: Here Is Why It's Underperforming In 2023 And May Continue To Do So

2023-08-21 02:22:39 ET

Summary

• JPMorgan Equity Premium Income ETF is the most popular covered call ETF with $29 billion AUM.
• JEPI's unique approach of selecting low volatility stocks (defined by low Beta) works well in bear markets but underperforms in bull markets.
• When you combine the selection of low Beta stocks with writing covered calls against SPY, your underperformance will be multiplied by a factor of 2-3x.
• The fund's approach shouldn't even be called covered calls because it sells calls against a basket of stocks that are different than what it holds (thus not truly covered).

JPMorgan Equity Premium Income ETF ( JEPI ) is probably the most popular covered call ETF in the market today with its AUM (Assets Under Management) of $29 billion is larger than most of its competitors combined including its sister fund JPMorgan Nasdaq Equity Premium Income ETF ( JEPQ ). The fund gained a huge popularity last year when it offered low volatility, safety and well-covered dividends in 2022 while the rest of the market was in turmoil but things have changed in 2023 as the fund's performance leaves a lot to be desired. In this article I will discuss the reasons why it underperformed (something no analyst seems to have noticed so far) and offer my commentary about its implications.

JEPI uses a unique approach which works greatly during a bear market but not so great during a bull market. The actively-managed fund picks stocks that are likely to have low volatility based on their beta scores. Of course this is not the only criteria used for selection but it's one of the most important ones. Beta of a stock tells us how much a stock will move in proportion to its benchmark index (most often S&P 500) and can technically range from 0.01 to 5+ but a great majority of Beta values of stocks will fall between 0.5 and 3. A Beta value of 1.0 implies that the stock moves in the same magnitude as S&P 500 index ( SPY ) while a Beta value of 0.8 would tell us that the stock is moving at a rate 20% slower than SPY in either direction which means when SPY is up 1%, this stock will be up 0.8% and when SPY is down -1% this stock will be down -0.8% in most days. A Beta value above 1.0 means that the stock is more volatile than the SPY. For example, 2x leveraged ETFs often have Beta values of 2 and 3x leveraged ETFs often have Betas around 3.

Having a portfolio of low Beta stocks have an advantage during a bear market where your stock holdings will drop less than the overall market. For example if you build a portfolio whose average Beta is 0.8 and S&P 500 index experiences a drop of -20% your stock holdings are expected to drop -16%. But this works both ways. When you are in a bull market where the index climbs 20%, your stocks will climb only 16%.

At first you might think this is no big deal, I will take a 4% underperformance if it will provide me with safety but JEPI has underperformed by a lot more than 4% this year. In fact it underperformed by a factor of 3x. What gives?

Here is something no one seems to have noticed. The fund holds its own set of stocks but it writes covered calls against the index . This is very important to note and I've never seen any analyst actually call it out. What this means is the fund is long its holdings and short SPY. When its holdings underperform SPY it's one thing but when it's underperforming SPY and shorting SPY at the same time, it will actually multiply the effects of underperformance. Technically this shouldn't even be called "covered call" because covered call means you actually own the stocks or index against which you are writing calls to but JEPI doesn't own SPY and it owns a basket of stocks that are going to underperform SPY during a bull run (due to low Beta) so it's not really covered calls.

Let's say you have a portfolio of 50 stocks worth $10,000 and this portfolio has a Beta of 0.80. Then you are writing covered calls against this SPY to cover it. Let's say during the year SPY is up 20% and your portfolio is up 16%. Since you wrote "covered" calls (but not really covered) against SPY your portfolio will take another 6-8% hit from this depending on your strike price. Now you go from underperforming SPY by 4% to underperforming by about 10-12%. Multiply this over years and you will be looking at pretty scary results.

On average a bull markets lasts about 7 years and bear markets last about 1 year. On any given year, the market is 88% likely to be in a bull market and only 12% likely to be in a bear market. This is why the market goes up in the long run. Bull cycles are a lot longer than bear cycles and they are a lot larger in size too. The average bear market drop is -35% whereas the average bull market gain is 200%. What this means is low Beta portfolios like JEPI will underperform the markets 7 out of 8 years.

What's the solution? Well a good start would be actually write covered calls, meaning only write calls against the stocks or indices you actually own. If you own one set of stocks and write calls against another set of stocks, you are not writing covered calls and you will underperform twice or triple as badly when your stock selections underperform.

Many people seem to think that JEPI is underperforming because VIX is down which is affecting the option premiums received by the fund but this would only affect the dividend distributions. The real reason it is underperforming is because it's shorting SPY while SPY is having a stellar year while JEPI's own holdings aren't having as good of a year by design because they are low Beta stocks.

You might be wondering why JEPI's sister fund JEPQ is not having this problem. Actually even though these funds are run by the same company, their approaches are vastly different. I've explained it in this article in detail: 3 Reasons JEPQ Is Different From JEPI so please read it to get a clearer picture.

In conclusion, I am not saying you should sell or short JEPI but be aware of the fund's strategy and please understand its long-term implications so that you know exactly what you are buying and what you can expect from it. Many times investors lose money because they buy something they don't truly understand. JEPI will outperform during a bear market but it will underperform during a vast majority of bull markets and this underperformance will be multiplied because of how the company chooses to do "covered" calls which aren't really covered calls.

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