XYLD - JEPI: Here's Why You Probably Should Not Own It

2023-03-07 13:32:53 ET

Summary

• JEPI has become a very popular ETF for dividend investors recently.
• However, JEPI is not an innovative approach and investors need to be wary of investing in a more complex and actively managed fund.
• From our analysis, we conclude that JEPI is not a good fit for most investors.

Investment Thesis

Investors are often lured by promises of high returns and high dividend yields only to be disappointed with the end result later on. JPMorgan Equity Premium Income ETF ( JEPI ) is the latest fad for investors chasing higher yield, but they may not be getting exactly what they expect. We dug into the details of JEPI that highlight it is really just a previous mutual fund offering wrapped up inside an ETF structure and promising yields that haven't proven greater returns in the last decade. An inception at the bottom of the market has created a track record for JEPI that is not sustainable nor should it be expected to continue.

What Is JEPI?

JEPI is a high-yield income ETF offered by JP Morgan. The fund aims to provide monthly distributions with equity exposure but with lower beta and volatility than traditional equity portfolios. The fund targets an annualized yield of 6-10%, through dividends (1-2%) and option premium (6–8%); breakdown from JEPI is shown below. Its lowered beta (0.6–0.7 versus the broader market, which by definition is 1.0) is achieved by overlaying a covered call strategy on top of a defensive bottom-up equity portfolio.

Covered Call 101

Before diving into the details of JEPI itself, let’s do a quick refresher on covered call strategies.

A call option gives the buyer the right, but not the obligation to purchase the underlying stock (index, commodity, etc.) at a fixed price at a future date. For this benefit, the option purchaser pays a premium. JEPI is taking the opposite position; it is selling call options to collect that premium. Below is a payoff chart showing the profit or loss (y-axis) as the underlying stock price changes (x-axis).

Payoff Diagram

To execute a covered call strategy, the portfolio manager also holds an investment in the underlying stock(s) while selling a call on that same underlying asset. If we combine the payoff structures of both the stock and selling an option, it looks as follows:

Payoff Diagram

The maximum loss would occur if the stock went to zero, but the investor would still get the premium; thus, the maximum loss equates to the value of the stock minus the premium. This is partially how JEPI reduces overall volatility.

Conversely, the best payoff occurs when the stock price increases to just below the call price. The holder would keep the underlying and collect the full premium. Any further increases in the stock price would not give the investor additional value and would be detrimental because it would be more costly to reinvest the money in the stock that was "called away."

Together, the strategy produces a dampened downside and a capped upside. In a declining market, this covered call approach would produce better results and less volatility. Similarly, it can produce an additional level of return in a flat market. However, in a bull market, it will not capture the full upside.

What Factors Influence The Value Of The Option Premium?

An option's value is based on several factors: the time to expiry, the volatility of the underlying asset, prevailing interest rates, the strike price, and the current underlying price. Changes in any of these factors influence the amount of premium JEPI will receive from selling the call options. However, given the objective of the fund, a number of these elements don’t vary significantly from period to period. Given the fund's objective to lower beta exposure and volatility, the fund manager is likely to keep the time to expiry and out-of-the-money component consistent over time. Volatility and interest rates are subject to change in different time periods and are likely the primary factors influencing the option premium. Variable changes in these variables cause fluctuations in the premium value, similar to ETF distributions.

Composition Of The High Yield

The fund has an annualized target yield of 6–10%+ through: 1) a dividend of 1-2%; and 2) an options premium of 6-8%. The remainder of the potential return comes from equity market exposure, which is variable. The fund is expected to perform well in an environment with higher volatility and could outperform the broader index during a downdraft, but is expected to underperform when the market is heading into a sharp rally.

Do Covered Call Strategies Outperform?

Theoretical academic papers suggest no outperformance for covered call strategies, while empirical approaches produce mixed results. Thus, we are evaluating financial products with similar objectives to JEPI in assessing performance. Global X S&P 500 Covered Call ETF ( XYLD ) commenced in June 2013, providing nearly 10 years of data for a S&P covered call ETF. Below shows the XYLD historic returns .

The return deficit strictly for the S&P 500 is stark, with an annualized underperformance of more than 500 basis points. But XYLD does maintain a beta slightly lower than JEPI at 0.56 (vs. S&P 500, Feb. 2023) and may be selling its calls closer-to-the-money.

Other long-running covered funds, such as Madison Covered Call & Equity Income Fund ( MENAX ), exhibit comparable underperformance. The chart below highlights the historic return of MENAX .

We would be short-sighted as investors to think that past performance will dictate future performance, but it certainly warrants scrutiny when evaluating this investment strategy. Additionally, the prospectus explicitly refers to income and risk reduction enhancement and not overall outperformance suggests that the managers will not necessarily seek additional return even if presented with the opportunity.

JEPI Under The Covers

The majority of the holdings in JEPI (114 of 127 positions) are equity and REIT positions, which represent close to 83% (as of January 31, 2023) of the total equity holdings. This portion of the portfolio is actively selected and, at the moment, has a sizable underweight to the information technology sector. This, in combination with a few other sector wagers (overweight utilities and consumer staples, underweight consumer discretionary), shows the portfolio clearly has a defensive tilt (active selection). Our key takeaway is that the underlying stock selection in JEPI is under active management and is likely to suffer long-term underperformance. Per our analysis, there is no indication that JEPI's portfolio managers have superior stock selection abilities, especially given they are competing in the most difficult segment (US large cap equity).

Dec 31 2022. The benchmark is the S&P 500.

The "convertible bonds" sector shows up in the footnote saying that it may contain equity linked notes (ELNs), but in reality, that is all that it contains. On February 17th, at the time of writing this article, the collection of holdings made up 15.6% of the fund by market cap. If you are asking yourself, "Where are the short-call positions?" there aren’t any. The covered-call exposure is made up entirely within the ELNs.

The following ELN detail is outlined in the JEPI Prospectus :

ELNs are structured as notes that are issued by counterparties, including banks, broker-dealers or their affiliates, and that are designed to offer a return linked to the underlying instruments within the ELN. ELNs in which the Fund invests are derivative instruments that are specially designed to combine the economic characteristics of the S&P 500 Index and written call options in a single note form and are not traded on an exchange.

Essentially, instead of actually selling call options on the portfolio or the S&P 500, JEPI purchases products that offer the same exposure. We identified a few new risks and concerns based on the ELN approach:

1. The covered call exposure is offered by counterparties, which comes with credit risk and counterparty exposure that may not be expected by most investors. The level of risk is likely small in normal market conditions, but has potential meaningful implications in "black swan" situations. Investors are not informed of the identity of the counterparties.

2. There is no free lunch. Embedded in the ELN will be profit margins or spreads for the ELN issuer. No institution is going to offer this product for free, and so we must assume there is an additional fee structure here that is not captured in the MER. Ultimately this will cause a drag on returns.

3. In extreme cases, the pricing of derivatives and their underlying can diverge from what is normally a direct link. JEPI is no exception in this case. Given that the details of the ELN are not precisely known to investors, it is possible that this risk could be amplified, we are simply not given enough information to make that assessment.

4. Given that the underlying equity exposure deviates from the S&P 500, covered calls against the S&P 500 create an additional source of risk as the underweight portion of the tech sector could be construed as not being a covered call but short a naked call.

The chart above shows a breakdown of the ELNs. The Security Name column starts with either SPX or NDX; this details what the underlying note is structured against, the S&P 500 for SPX or the Nasdaq 100 for NDX.

Note that although the NDX delta and gamma details were provided at the time, the fund did not show any NDX ELNs within its holdings, and based on its prospectus, it would not be expected to do so at any time in the future. The $4,090.41 reference price was the S&P 500 closing price on February 16, 2023.

A key takeaway thus far is that there is a deviation between the underlying holdings and the short call exposure. Remember that the equity holdings of the portfolio had significant deviations from the index, and yet the short call exposure is based upon the index. This is not in itself an inherently bad distinction, but it is certainly a source of risk and a source of deviation from expected investor performance. If the information technology sector were to suddenly outperform significantly, JEPI would show underperformance from both the underweight of the sector and the short call through the ELN.

Expectations

JEPI started in May of 2020 during the pandemic-induced market trough, creating a bias with regards to its performance since inception. However, the mutual fund structure equivalent, JPMorgan Equity Premium Income Fund ( JEPIX ), has been around longer and gives us slightly more clarity on return expectations. Both funds are run by the same portfolio managers and have nearly identical holdings, although JEPIX has a higher expense ratio.

F is JEPIX, B1 is the S&P 500.

Over a nearly 5-year period, the fund has slightly underperformed the S&P 500. Part of this could be attributable to the defensive equity exposure, covered call strategy, and individual stock selection. However, it is consistent with the fund's objectives because it is not stated in the prospectus that the fund sought to outperform the S&P 500. Its objective is to provide an equity exposure with monthly distributions funded through dividends on the underlying equities and the sale of call options.

Looking closer at JEPIX’s portfolio summary, we see that it is largely aligned with the stated objective.

JEPIs Recent Outperformance

So far, we have largely covered the impact of the covered call exposure within JEPI. Equally important is the underlying equity strategy. As mentioned above, JEPI holds a significant underweight in information technology while being overweight in consumer staples, utilities, and industrials.

To assess the impact of the defensive strategy, we looked at individual sector-specific ETFs and their relative performance.

• VDC: Vanguard Consumer Staples ETF

• VPU: Vanguard Utilities ETF

• VIS: Vanguard Industrial ETF

• VGT: Vanguard Information Technology ETF

• GPSC: S&P 500 Index

Yahoo Finance - 2 year return

For the two-year period shown above, we show that the defensive strategy has been very well executed. All three overweight sectors outperformed the broader index, while the significantly underweight information technology sector underperformed. This explains why JEPI has been producing equity-like returns in its relatively short life with less volatility, given that it has perfectly pegged the correct sector exposure (along with the vast majority of other defensive and value factor funds).

However, as we extend the return analysis back an additional 3 years we see a vastly different picture. All its hand-picked overweight sectors underperformed the broader index, while information technology significantly outperformed.

Yahoo Finance - 5 year return

We emphasize that the result of having a mid-2020 conception date and a defensive strategy led to JEPI’s marvelous outperformance relative to its peers and the broader index. But there is a significant bias when evaluating a strategy in such a short time period. Suffice it to say, JEPI had a nearly perfect start date, and the outperformance may not last.

Upside Potential

Given the large amount of uncertainty in the market right, potentially flat or declining market and higher interest rates (creating somewhat large option premiums), we believe there is certainly a possibility of JEPI outperforming in the short term. Increased market volatility or a continued flat/declining market would further add to factors favoring JEPI in the short term. Market/industry timing carry risks but under the right set of circumstances these exposures could provide outsized performance.

Who Should Own It and Who Shouldn't?

If the fund does not seek outperformance but merely a monthly distribution and lower volatility with equity exposure, then for whom does it make sense?

• Are you holding out for the long term? If so, JEPI is probably not for you, as higher fees and an active management style won’t likely lead to outperformance in the long haul.

• Are you holding JEPI in a taxable account? If so, it is probably not for you, as the distributions are largely not qualified due to the nature of the income from selling the options, leaving this taxable as income. Canadian investors should be especially wary of purchasing JEPI in their TFSA as it will have a significant withholding tax drag.

• Do you require a consistent monthly distribution? If so, JEPI is likely not your best choice, as the nature of the strategy will have significantly higher volatility in the monthly distributions.

If you answered yes to any of the above questions, you should reconsider investing with JEPI. And we believe JEPI is not suited for most investors as a core for equity exposure.

Conclusion

In our view JEPI is a fund that is exactly as it claims to be, with a few wrinkles that all investors should understand before investing. But whether most investors understand what it claims to be remains less clear.

It is not certainly a new or innovative strategy but rather a decades-old one, and it should really only be held by a small sect of investors whose objectives align with the fund's objectives to a tee. If you are not one of these investors, we would recommend looking elsewhere for your equity and income exposure.

The fund's nearly perfect timing has attracted a significant number of investors who may be unaware of what they've signed up for and, in many cases, are likely chasing yesterday's winner.

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