MSFT - SPYI: Superior To JEPI In Every Single Way

2023-05-24 17:11:55 ET

Summary

• Neos S&P 500(R) High Income ETF is a high-income exchange-traded fund that utilizes a unique covered call strategy while also owning all the securities inside the S&P 500 Index.
• This approach allows the SPYI ETF to pay double-digit distribution percentages on an annual basis while utilizing the tax efficiency of S&P 500 Index Options.
• These double-digit distribution percentages are paid out in the form of cash to shareholders on a monthly basis.

Since debuting on the public markets in Q2 of 2020, the JPMorgan Equity Premium Income ETF ( JEPI ) has quickly become one of the most popular income-focused exchange-traded funds, or ETFs. Now, just three years later, the JEPI ETF's assets under management have grown to over $25 billion.

However, I'd argue there's a better ETF out there for income-focused investors who might also care about tax efficiency and the potential for equity appreciation.

Introducing the Neos S&P 500((R)) High Income ETF ( SPYI ).

SPYI's Objective

Here's a look at SPYI's investment objective based on the issuer's website :

The NEOS S&P 500 High Income ETF seeks to generate high monthly income in a tax efficient manner with the potential for equity appreciation in rising markets.

SPYI is an actively-managed exchange-traded fund that seeks to achieve its investment objective by investing in a portfolio of stocks that make up the S&P 500 Index and a call options strategy, which consists of a mix of written (sold) call options and long (bought) call options on the S&P 500 Index.

Let's break down their above investment objective step-by-step, compare it to JEPI, and decide which ETF best belongs inside an income-focused investor's portfolio.

The Breakdown

"An ETF that seeks to generate high monthly income..."

According to the SPYI Prospectus…

" The Fund seeks to generate high income from the premiums earned from the SPY call options as well as the dividend received from the fund's equity holdings. "

The above statement means two things:

1. As a shareholder in SPYI, you're receiving the normally scheduled dividends paid out by the hundreds of companies inside the S&P 500 Index (SP500) that this ETF has exposure to.
2. And you're also receiving monthly cash distributions paid for by the premiums that are generated by this fund's call option strategy on the S&P 500 Index.

Just so we're all on the same page about their call option strategy, let's quickly walk through how this generates income for the fund.

A "covered call" is an option contract where the seller of the contract also owns the underlying stock or ETF they plan to sell. Selling a covered call to a third party gives the buyer of the contract the right to purchase the underlying security at an agreed upon price (strike price) by an agreed upon date (expiration date). Every option contract has a buyer side and a seller side. In this instance, SPYI is the seller.

1 option contract = 100 shares of the underlying security, which is often a stock or ETF. However, in SPYI's case, it is the S&P 500 Index as made available by the CBOE.

As it relates to generating income for the fund's shareholders - when selling the call option contract, the seller earns a "premium" in the form of cash. This is the cash used to pay monthly distributions to SPYI shareholders.

However, if the underlying security's price goes above the strike price by the expiration date, the fund would be required to sell 100 shares per contract sold at the strike price.

Covered Call Example

Let's use Microsoft Corporation ( MSFT ) stock as an example. To buy 100 shares of Microsoft today, you would spend $31,918 as the stock price is currently $319.18. If you owned 100-plus shares of MSFT and you believe the stock price will remain stagnant or even begin to come under pressure, you may be enticed to sell a "covered call" and collect a cash "premium" paid to you by the buyer.

Or perhaps you have 500 shares of the underlying security and want to lower your position to recognize some of those gains - in this instance, you would also want to sell a covered call.

For example, let's say you wanted to sell a $325 covered call option on MSFT, as shown in the option chain above. You could earn a premium of $6.35 per share, or $635 for the entire contract. When a buyer agrees, you will receive the $635 cash premium into your account immediately.

If by the expiration date (June 30), the shares of MSFT are trading below $325 (strike price), you keep the $635 as profit and the option contract is considered worthless because the option buyer would be better off buying shares on the market, which is lower than the strike price.

But if by the expiration date shares of MSFT rise above the $325 strike price, say to $330, you would be required to sell your shares for $325 to the option buyer. They instantly buy the shares at $325 that are worth $330, so a $5 per share gain for them, the option seller would not partake in.

Now let's talk about the risk. The risk the seller is taking on by selling these covered calls is the risk of losing out on potential upside, assuming the underlying security trades above the strike price and the buyer exercises their contract.

To mitigate this risk, you could sell covered call options on MSFT further and further "out-of-the-money," which would lower your chances of actually having to sell the shares to the buyer at a price lower than what the open market is paying. However, the higher the strike price, the lower your premium might be.

We're only scratching the surface with options, as there are countless strategies used to achieve numerous outcomes. With that being said, it makes a lot of sense as to why investors use this strategy to generate income with their portfolios.

"...in a tax efficient manner..."

Now that we're all on the same page as to how this fund generates income for its shareholders, let's further delve into how it achieves this in a tax-efficient way.

Unlike JEPI and their ELNs (equity-linked notes), SPYI takes advantage of the tax efficiencies afforded to Section 1256 contracts by the Internal Revenue Code. Essentially, Section 1256 contracts allow income distributed to SPYI shareholders to instead be taxed as both long-term and short-term capital gains - compared to just short-term capital gains with ELNs.

"For Section 1256 contracts, the tax on the gain or loss is treated as if 60% of contracts were held as long-term investments and 40% as short-term investments." - Investopedia .

The fund also mentions in their prospectus their intention to take advantage of tax loss harvesting opportunities on the SPX call options and / or equity positions.

"In addition, the Fund may seek to take advantage of tax loss harvesting opportunities by taking investment losses from certain equity and/or options positions to offset realized taxable gains of equities and/ or options. Opportunistically, the Fund may seek to take advantage of tax loss harvesting opportunities on the SPX call options and/ or equity positions."

Because SPYI utilizes these strategies, shareholders can expect less of a tax burden on their gains when Uncle Sam comes knocking in April.

"…with the potential for equity appreciation in rising markets."

Now, this is what really sets SPYI apart from JEPI - the potential for equity appreciation in rising markets.

JEPI is very straightforward with their intention to write covered calls against at least 80% of their assets, as well as invest up to 20% of their assets into ELNs. Essentially, this means JEPI's entire fund is being used to generate income for their investors.

SPYI is very different - according to their prospectus, the fund's options strategy typically consists of two components:

1. Covered call options on up to 100% of the value of the holdings.
2. Using a portion of the premium received from those covered call options to then purchase out-of-the-money call options on the S&P 500, providing the potential for upside in case the S&P 500 meaningfully appreciated in value.

Here's why that's so important - the "up to 100%" callout means there is absolutely the possibility that not all the fund's holdings are tied up in option contracts, allowing them to move up (and down) with the markets.

This means SPYI investors have the opportunity to capture potential equity appreciation as the S&P 500 moves higher. Additionally, the out-of-the-money call options may offer upside participation as well.

This outperformance potential is made very clear when you compare the equity appreciation between SPYI and JEPI year-to-date.

The illustration below includes total return.

At the time of writing this, SPYI shares are up 5.1% while JEPI shares are down -0.3% year-to-date. Over that same period of time, SPYI has paid out a 3.9% distribution yield to shareholders, while JEPI has only paid out 3.2%.

This brings SPYI's total return YTD to 9.02%, while JEPI's total return YTD is only 2.96%.

Since SPYI's inception in August 2022, SPYI's total return as of the time of writing is 6.70%, while JEPI's total return is 6.01%.

Investor Takeaway

JPMorgan Equity Premium Income ETF is a fine product and deserves to be inside income-focused investors' portfolios. However, I'd argue Neos S&P 500((R)) High Income ETF is superior to JEPI given its higher monthly distribution, tax efficiency, and potential for equity appreciation. When compared to JEPI year-to-date, it seems to have outperformed on every measure.

And as an income investor myself, I'm surprised more investors don't know about the obvious benefits of choosing Neos S&P 500((R)) High Income ETF over JPMorgan Equity Premium Income ETF, given its healthy outperformance thus far in 2023.

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