2023-03-25 02:46:17 ET
Summary
- The JEPQ provides investors returns that broadly track the NDX, but with reduced volatility and significantly higher income from the sale of call options on the NDX.
- With the NDX looking extremely overvalued once again, now is a good time to shift out of NDX and into JEPQ as income returns should far exceed any capital gains.
- The JEPI yields 14.6% due primarily to the premium received from selling options, as well as the dividends received on the equity portfolio.
- Actual positive returns are unlikely, however, as the nature of bear markets is such that they tend to be driven by panic, which causes sharp losses, which the JEPQ would suffer, as well as sharp interim recoveries, which the JEPQ would only partially benefit from.
The JPMorgan Nasdaq Equity Premium Income ETF ( JEPQ ) follows a strategy of generating income through a combination of selling options and investing in US. The fund seeks to deliver a monthly income stream from associated option premiums and stock dividends, while delivering a significant portion of the returns associated with the Nasdaq 100 Index with less volatility. Now is great time for anyone invested in the NDX to shift to the JEPQ to protect against downside. However, while the JEPQ is highly likely to outperform the NDX in a bear market, actual positive returns will be difficult to achieve.
The JEPQ ETF
The JEPQ's investment objective is to seek current income while maintaining prospects for capital appreciation by employing an actively managed portfolio of equity securities comprised predominantly of Nasdaq 100 stocks, while selling out of the money call options on the NDX itself via equity-linked notes (ELNs). The ETF is designed to provide investors with performance that captures a majority of the returns associated with the NDX, while exposing investors to lower volatility and also providing incremental income. The fact that the JEPQ ETF sells out of the money call options means that it tends to be slightly more volatile than the Nasdaq 100 Covered Call ETF ( QYLD ) which I wrote about here .
Currently the ETF's equity portfolio is very similar to the NDX, although it is slightly more diversified and less top-heavy, with MSFT and AAPL comprising 10% and 9% of the index versus 12% of the NDX. While the ETF has only been around since May last year, it has done what it intended to since inception. Its equity portfolio has a been less volatile than the NDX, while its call sales have allowed the fund to generate returns on a par with the NDX. The JEPQ has generated income returns of almost 13% on an annualized basis since its inception, and the 30-day SEC yield is now as high as 14.6%. The fund charges a reasonable expense fee of 0.35%.
Resumption Of The NDX Bear Market To Drag JEPQ Lower
I am bearish towards the NDX as valuations remain extremely elevated in the context of a weakening revenue growth and still-elevated real interest rates ( see 'QQQ: Lower Rates Are No Reason To Be Bullish' ). As the chart below shows, the free cash flow yield has collapsed back to near its 2021 lows even as 10-year inflation-linked bond yields remain near cycle highs.
NDX FCF Yield Vs 10-Year TIP Yield (Bloomberg)
I am actually short the NDX via selling out of the money naked calls (not owning the underlying NDX itself) to benefit from the high option premium and my expectation that the market will move lower. If I am right about the NDX declining then the JEPQ is highly likely to decline too, but at least holders will receive substantial monthly income which is likely to average over 1% a month. Furthermore, any declines in the NDX would likely occur alongside a rise in implied volatility, which would cause income returns to rise further.
We could possibly see the JEPQ post positive returns even in the event of a NDX bear market. As we saw in the final quarter of last year, the JEPQ outperformed the NDX by 13% annualized, squeezing out a small gain despite NDX weakness. A gradual decline in the NDX as was the case then would allow the JEPQ to generate enough monthly income to offset any capital losses. That said, such an outcome is still highly unlikely as the nature of bear markets is such that they tend to be driven by panic, which causes sharp losses, which the JEPQ would suffer, as well as sharp interim recoveries, which the JEPQ would only partially benefit from.
I therefore would only recommend the JEPQ for anyone who has a long only mandate, and even then, the QYLD offers an even lower volatility option for NDX exposure. However, for those willing and able to take short exposure, a long JEPQ position could be combined with a partial or full short position on the NDX as a means of generating strong income without the downside risk.
Summary
The JEPQ is a good alternative to the NDX for investors who wish to have exposure to the tech sector while generating income and limiting volatility. The fund has generated 13% annualized income returns from call option sales since its inception last year, and future returns look set to be even higher, which should allow the JEPQ to significantly outperform the NDX over the coming months and years. The overvalued nature of the NDX relative to real bond yields and the growth outlook suggest renewed equity market weakness, which is likely to drag down the JEPQ at least in the short term.
For further details see:
JEPQ: Outperformance Likely But Positive Returns Will Be Difficult