JEPI - Why I Sold Out Of JEPQ

2023-12-18 21:07:30 ET

Summary

• I bought JEPQ when it was young on Nov 8, 2022. I also wrote the first SA article about it on Nov 24, 2022.
• The reasons I no longer like JEPQ include macroeconomic changes, crowding issues, and technical changes in the option markets.
• I'm still constructive on the overall market. There are just better ways to play it.

Over the last 18 months there has been an explosion of interest by retail investors in covered call strategies. These strategies have been around for decades but were energized by the ETF from JP Morgan, [[JEPI]]. This covered call strategy is based on the S&P 500. It went from zero to a current market cap of $30 billion, making it one of the most successful ETF launches ever. On the back of this JP Morgan launched a similar NASDAQ-centered ETF JPMorgan Nasdaq Equity Premium Income ETF (JEPQ). It is based on the QQQ index, and its market cap is currently $7.6 billion. As expected, a number of other Wall Street firms launched copycat products, including Goldman, Amplify, and several others. It has also led to an increase in AUM for existing call writing funds such as [[QYLD]].

The strategy of both JEPI and JEPQ are similar. They are actively managed. They buy a basket of stocks that has a high correlation to the market index in question but with lower volatility. This basket also has a higher dividend yield than the index. They then write call options against the index. The combination of dividends and option premia provides a good return. Moreover, if the market doesn’t go up too quickly, the fund will more or less keep pace with the increase. If the market goes down, the options provide some protection.

This strategy has worked well. From JEPQ’s inception on May 4, 2022 it has gained 17.1%. (I’m doing these calculations assuming all dividends are reinvested.) The pure NASDAQ index fund QQQ has gained 23.8% but at the cost of higher volatility. The maximum drawdown in JEPQ was 16.8% while that for QQQ was 21.6%. So JEPQ has provided a near-market return while letting its owners sleep better at night.

So why did I sell?

First, it seems clear to me that interest rates have peaked. I always suspected that they were artificially kept high by the anomalous 5+% GDP growth in Q3. Estimates for Q4 are in the 2.0% to 2.5% range. This was confirmed by the Fed’s statement and forecasts of Dec. 13. The market is now pricing in about six cuts next year. (I base this on the SOFR futures market.)

This will have a large impact on the risk appetite of investors. The sharp rise in rates led many to abandon risk assets for safe alternatives like money market funds. (BTW, that includes me.) According to the Fed’s statistics , MMFs have seen an inflow of over $1 trillion in the last eight months! And why not? If you can earn about 2.5% above inflation with near zero risk, take it.

But times have changed. Real rates have gone down by 70 basis points in the past month. Over time this will shift funds back into risky assets, and lead to at least a generally buoyant market. In this type of market, JEPQ will underperform. The underperformance will be intensified by the mismatch between JEPQ’s stocks and options. Remember that JEPQ doesn’t hold the full NASDAQ; it holds a low volatility subset. OTOH it writes options on the full NASDAQ.

Second, the options writing trade has gotten very crowded. The direct ETFs and mutual funds that do this are now well over $100 billion. Additionally, many investors, institutions and hedge funds use this strategy as well. Investors new to options should note that there is a whole class of hedge funds running volatility strategies. This mostly involves writing options and continually delta hedging. As long as it’s profitable, that’s not a problem. But like all crowded trades: should something happen to reverse the setup, Katie bar the door!

It’s important to realize that writing options is equivalent to selling insurance. Insurance is generally a good business, but there are times when there is too much capacity, and premiums go below the level appropriate for the risk involved. In the property insurance market, for example, this usually happens when there haven’t been many major disasters for a few years. I believe that’s where the stock options market is now.

This brings me to my final reason. Option volatilities are too damn low! Here’s a table of QQQ implied vols over the past year from optioncharts.io:

Implied Volatility - QQQ

So we are basically at yearly lows for QQQ vol. In fact, the only time in history I could find where implied vol was lower was in the second quarter 2017. In most mean reverting markets, like implied vol, selling near all-time lows is not a good idea. Other measures of option pricing like option skew and historical volatility are also near record lows. This site offers some good charts if you want to go further.

So what did I do with the money from my liquidation of JEPQ? I put it in an index fund. As I said, I’m generally constructive on the overall market. I just don’t want to be short options.

This is my first article in some time. Circumstances have prevented me from writing for a while. I'm thinking of starting an investing circle in SA. It would be aimed at somewhat experienced investors. It would be free and focused on sharing shorter-term ideas than my long-form articles. I would hope that everyone in the group would have ideas to contribute. Let me know if you think it's something you might want to join.

For further details see: