2023-05-03 10:33:23 ET
Summary
- There are multiple indicators pointing to an extended economic slowdown; markets should remain volatile for some time.
- The JPMorgan Nasdaq Equity Premium Income ETF is likely to both outperform and be more volatile than the broader indexes during a recession.
- Traditional dividend investors likely won't want to be in this heavily concentrated fund, but aggressive individuals seeking income may find this ETF appealing in a more volatile market environment.
The investing environment is very fluid right now. While individuals had an easy time getting consistent income and total returns for much of the last decade when markets were rising consistently and rates remained low, the economic situation has become much more volatile over the last three years with inflation and now growing signs of a prolonged slowdown. Dividend investors in particular are having a more difficult time getting inflation-adjusted returns with prices consistently rising at above 6% since early 2021.
One type of investment that has become increasingly popular for dividend and income investors is a covered call fund. The JPMorgan Nasdaq Equity Premium Income ETF ( JEPQ ) is becoming one of the more well-known covered call funds that sells Equity-Linked notes against the fund's holdings. An Equity-Linked Note ((ELN)) is a debt instrument, usually a bond, where the payout is based on the underlying asset the option is sold against. The underlying equity of the ELN can be a collection of stocks, a single stock or an equity index. This fund sells one month out-of-the money call options against the individual's holdings as well as the index, the Nasdaq 100. The income derived from selling the ELNs along with the dividends paid by the fund's holdings enable this ETF to make monthly distributions.
Today I rate JEPQ as a Hold. The fund lacks diversity since the top four holdings make up just over 30% of the fund, and many of this ETF's core investments are also in cyclical companies such as Alphabet ( GOOG ) and Nvidia ( NVDA ) that should get hit hard if the economy enters a prolonged recession as is looking increasingly likely. This ETF's four largest holdings are Amazon ( AMZN ), Apple ( AAPL ), Microsoft ( MSFT ), and Alphabet ( GOOG ). Still, the volatility in this fund should create a strong opportunity for more aggressive income investors who can handle potentially significant short-term losses to the principal.
JEPQ has been significantly more volatile than most income and dividend-based funds and the broader indexes primarily because this ETF loosely tracks the Nasdaq 100, which is a part of the overall Nasdaq index that has minimal diversity. This ETF is less volatile than the Nasdaq 100 since the fund also has 6% of the fund's assets invested in the health care sector, 6% in the consumer defensive sector, and 16% in the communication sector. JEPQ is 48% invested in technology stocks. This fund is down 11.12% in the last year, while the S&P 500 has only fallen 2.43% during this same time, and the Nasdaq has fallen 5.57% during that time period. Some of this fund's peers, such as the JPMorgan Equity Premium Income ETF (JEPI) and the Amplify CWP Enhanced Dividend Income ETF (DIVO) have also been less volatile than this ETF. JEPI is down 8.55% in the last year, while DIVO has only sold-off 1.6% during this same timeframe.
Covered call funds such as JEPQ perform best when volatility levels are heightened because the greater premiums in the monthly options that these funds sell enable them to return more income to shareholders. These funds also have more risk than average investments in a volatile market, since the strategy these funds use sells off a significant part of the upside of the underlying investments that are held. Out of the money options also tend to have higher volatility premiums than at the money option contracts. This fund has a standard deviation of 21.41, which is lower than the Nasdaq 100, but still significantly higher than JEPI's standard deviation of 13.86 and DIVO's standard deviation of 15.37. This fund is also more volatile than the S&P 500, which has a 3-year standard deviation of 18.
Several major companies, including Disney ( DIS ) and Alphabet, have recently announced significant layoffs, and manufacturing and consumer confidence numbers also show the economy is likely to continue to slow in the coming months. The Fed has also remained committed to raising interest rates, with Powel recently reiterating that his goal remains 2% inflation. Overall volatility levels should remain elevated for some time. Even though this fund was started less than a year ago in early May of 2022, the monthly distributions this ETF pays have varied significantly based on volatility levels. In just the last year monthly distributions have ranged from a low of $.339 in July of 2022, to a high of $.68 in November of last year. Distributions are paid from the income generated over the previous month.
A Chart of Dividend Payouts (jpmorgan.com/us/en/asset-management/adv/products/jpmorgan-nasdaq-equity-premium-income-etf-etf-shares-46654q203#/dividends)
These distributions predictably correspond with the volatility in the market, with higher monthly payouts coming late last year.
A Chart of the VIX (www.cboe.com/tradable_products/vix/vix_options/?&&&&gad=1&gclid=CjwKCAjwxr2iBhBJEiwAdXECw9KiUVPS7QO6twSXPDIxc5EkEjJ6vvIM3mCa4r1AkdInN1bIGejpKRoChlIQAvD_BwE&gclsrc=aw.ds)
I believe this fund will likely significantly outperform most other covered calls funds as well as the broader indexes if a prolonged economic slowdown occurs and markets become more volatile. This fund has 25% of the ETF's holdings Apple ( AAPL ), Alphabet ( GOOG ), and Amazon ( AMZN ). All three of these companies are in more cyclical industries as well, and each can sell off hard during economic downturns. The standard deviation for JEPQ is 21.41, the heavy concentration at the top of this ETF makes this fund significantly more volatile than most covered call funds, including JEPI and DIVO. Since the higher volatility levels in this fund enable the managers to get high premiums in the monthly calls the managers sell against the fund's holdings, this usually enables covered call funds such as JEPQ to return more income to shareholders and outperform during periods of heightened volatility.
JEPQ is also an actively managed fund that is run by three managers, and these individuals use their discretion to change the holdings and sell ELNs against both index and individual holdings. This ETF is well positioned to be more aggressive with the fund's use of options when market conditions are ideal for this strategy. This fund reported a 195% turnover rate by mid-2022, the managers of this ETF are very active. JEPQ will likely be too volatile for traditional dividend and income investors. Still, for more aggressive individuals looking for income, this ETF should offer significant income in a recession.
For further details see:
JEPQ: This ETF Should Outperform During A Recession