AMZN - JEPI: Pain On The Horizon

2023-10-08 21:42:10 ET

Summary

• JPMorgan Equity Premium Income ETF offers a 10.58% 12-month rolling dividend yield, making it attractive to income and dividend-seeking investors.
• JEPI aims to generate income through selling options and investing in U.S. large-cap stocks - a strategy that may work well in some market regimes, but not all.
• The current macroeconomic picture suggests a more risk-off investing environment, which is not likely to favor JEPI's strategy.

Background

The JPMorgan Equity Premium Income ETF ( JEPI ) is a popular topic among income and dividend-seeking investors on Seeking Alpha and elsewhere--and for good reason. As of this writing the fund, according to its latest fact sheet , sports a 10.58% 12-month rolling dividend yield, which is an attractive return even in today's high interest rate environment.

The fund benchmarks itself against the S&P 500 Total Return Index and, according to its summary prospectus, has three core goals.

1. 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.
2. Constructs a diversified, low volatility equity portfolio through a proprietary research process designed to identify over and undervalued stocks with attractive risk/return characteristics.
3. Seeks to deliver a significant portion of the returns associated with the S&P 500 Index with less volatility, in addition to monthly income.

On a one-year timeframe, JEPI has performed solidly, if a bit behind the total return of the broader S&P 500 ( SPY ), with a 10% return for the time frame. Bulls will notch this return as a win since the main purpose for many investors in this fund is to collect dividends. On a price return basis, the fund has been relatively flat, eking out a 0.34% gain on a trailing twelve-month basis.

With some of the fund background out of the way, we'd like to consider the current situation for JEPI, and how the macro-economic picture in the near- to mid-term is likely to affect the fund. Let's dive in.

Holdings & Strategy

As of this writing, JEPI holds 196 positions with its largest holding, Amazon ( AMZN ), making up 1.61% of the portfolio and the top 10 positions in the fund have a 15.38% weighting overall.

Of the holdings, the largest concentration is (surprise, surprise), in the technology sector with a 13.6% weight, while energy comes in last with only 2.48% of the fund.

The strategy of the fund, according to its prospectus , is to invest a maximum of 80% of the fund's assets into equities and a remaining 20% of assets into equity-linked notes, known as ELNs. ELNs are a private party transaction between JEPI and banks or broker-dealers that don't trade on an exchange, but they feature an embedded covered call option that allows the fund's managers to structure the ELNs in a way that should produce a more efficient result than just going out into the market and selling individual calls on, say, Amazon.

The downside, however, remains the same as with all other covered call strategies, in that volatility is not the covered call investor's friend. Consider this snapshot from JEPI's quarterly commentary dated June 30th, 2023.

It may jump out at the reader that while the strongest performing sectors in the market were IT and consumer discretionary and the weakest were utilities and energy, the results for JEPI were almost inverse, with energy being one of the best contributing sectors and IT being one of the principal detractors from the fund's performance.

We remind readers that this is a feature, not a bug. When prices rise past the strike price (or agreed on price within the ELN agreement), the holder of the underlying equity position relinquishes their position, thus losing out on the subsequent gains of the underlying equity beyond the premium collected. Importantly, the holder of the equity position remains exposed to any downside in the stock.

In other words, those investing in covered calls may not find trending markets (to either side) to be ideal (we addressed this risk in a previous article, which you can read here for additional detail).

It is incumbent on the investor, then, to consider whether the dividend return is worth the downside risk that one is exposed to when holding a fund such as JEPI. A 10% dividend on an investment that has seen its value decline by more than that isn't necessarily attractive.

Where To Go From Here?

While nobody knows what the markets will do in the future, the current outlook for stocks and the equity market in general appears to have no shortage of storm clouds. Surging job numbers , the threat of higher-for-longer rates , the resumption of student loan payments in October (which could affect the thus-far impressive resilience of the American consumer), and the recent selloff in the bond market all seem to portend a more risk-off investing environment that is likely to be rocky for equities in the near term.

It should also be noted that in times when the market is not expecting equities to rally, the bid on call options tends to shrink as implied volatility is sucked out of the market--the same can be expected to happen for ELNs.

In this environment, the expected premium collected against equity positions is diminished. This only makes sense: in a market where few participants expect stocks to go up, it should be more difficult to find buyers willing to pay a premium for call options.

The Bottom Line

JEPI is by no means a bad fund--the strategy it employs is certainly one that will perform well in certain environments. We are just not convinced that the current environment is one that will do the fund's strategy any favors. Risks to our thesis include the possibility that the market has found a bottom and trades sideways for a significant amount of time. This risk would allow JEPI to collect healthy premiums against its positions without enduring losses to principal. Given the still-inflated nature of equity valuations, however, we think that this is unlikely.

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