Why I’m Not Buying The JPMorgan Equity Premium Income ETF (JEPI)

The JPMorgan Equity Premium Income ETF (NYSEARCA:JEPI) has become a star in the ETF landscape. Launched just two years ago, JEPI has already attracted more than $10 billion of assets under management thanks to its low management fee, high yield, and differentiated approach to generating income.

What Is JEPI’s Investment Strategy?

JEPI is not your typical covered call ETF. Instead of selling options on its own underlying holdings, it buys structured notes “ELNs” that replicate the returns of a covered call strategy with a portion of its funds. Here’s the explanation from the prospectus:

In order to generate income, the Fund may invest up to 20% of its net assets in ELNs. ELNs are structured as notes that are issued by counterparties, including banks, broker-dealers or their affiliates, and that are designed to offer a return linked to the underlying instruments within the ELN. ELNs in which the Fund invests are derivative instruments that are specially designed to combine the economic characteristics of the S&P 500 Index and written call options in a single note form.

What does the other 80% of the portfolio own? The fund owns a widely-diversified selection of individual stocks that are low volatility. Historically, there have been excess full-cycle returns in owning low-volatility stocks as opposed to the market as a whole. There is some intuitive sense to the idea of owning “low vol” stocks while layering on a call-selling approach on top of that to reduce volatility even more.

10% Yield Isn’t Free; The Call-Writing Greatly Limits Upside

It’s tempting to look at JEPI’s 10.6% dividend yield and think that this is a cash flow machine. While the stated yield is nice, you aren’t getting a free lunch.

Most of this dividend yield comes from the ELN strategy rather than dividends off of the ETF’s underlying holdings. This, in turn, greatly limits the overall gains that JEPI can be expected to achieve during bull markets.

Hypothetically, if you sell a call for a 5% premium, for example, you make 5% upfront, but don’t receive any further gains if the market goes up 8%, 12%, 15% or more. Meanwhile, if the market drops, say, 10%, the fund will still be down 5%, as the premium offsets only half the market loss. There’s another layer of complication here since JEPI uses ELNs rather than selling calls directly, but the same general framework applies.

We don’t have a huge track record for JEPI specifically yet, as it launched in 2020. However, there are much longer-running strategies that have existed in the own equities, sell calls against them space.

Specifically, for example, the CBOE operates an S&P 500 Buy-Write Index. It describes the strategy as follows:

“A “Buy-Write” strategy generally is considered to be an investment strategy in which an investor buys a stock or a basket of stocks, and also writes covered call options that correspond to the stock or basket of stocks.

Buy-Write strategies provide option premium income that can help cushion downside moves in an equity portfolio, but Buy-Writes often under perform stocks in rising markets. Thus, some Buy-Write strategies significantly outperformed stocks in 2000 when stock prices fell, but Buy-Writes tended to under perform stocks in the years 1995 – 1998 when the S&P 500 rose by more than 20% per year.”

And indeed, the Buy-Write strategy has underperformed dramatically in recent years, as it simply can’t keep up during bull markets. Here’s that CBOE S&P 500 Buy-Write index against the S&P 500 ETF:

While the buy-write index (purple line) has been less volatile than the S&P 500, that lower risk came at the expense of giving up more than half of the returns that would have been achieved from simply owning the SPY ETF.

Suppose someone created an ETF that owned the S&P 500, but sold 10% of its holdings every year and paid that out as a “dividend”. You’d get a 10% yield while owning the stock market. Sounds great, right? However, the total returns on the fund would be equal to the market, as your 10% “yield” would simply be the result of taking 10% away from your NAV each and every year.

Is a covered call ETF the same as this hypothetical SPY but sell 10% every year ETF I just described above? No, it’s not the same. But it’s much less dissimilar than you might first think.

JEPI’s Bottom Line

Over the long-term, investors shouldn’t expect the total returns of a covered call style ETF to deviate that significantly from the underlying index it is following. The main difference will simply be from beta; the ETF will be expected to go up less in good times and down less in bad times.

After all, if call options were significantly overpriced or underpriced, over time, hedge funds and quant/algo shops would arbitrage out the difference.

Despite JEPI’s more complex approach that may add alpha thanks to the use of ELNs and its low-vol selection strategy, the ETF has precisely matched the S&P 500’s return since inception:

While the dividends have been large, that has been offset by the share price rising less in return. And that’s as you’d expect. The yield from this sort of approach largely comes from selling away upside during rallies. This shifts returns, not generating them but rather smoothing them.

Would I buy JEPI shares today? No, I would not. We’re already well into a bear market. In my view, this is the time to be going on offense, rather than sticking to defensive holdings like JEPI.

I’d look to buy a more conservative market exposure such as JEPI when indexes are near their highs and optimism is in the air. To that point, consider the charts year-to-date. JEPI has held up much better than the market in 2022 so far:

Year-to-date, JEPI is only down 11%, versus a 22% decline for the S&P 500. The call-writing overlay and low-vol approach have cut losses in half. The flip side of that, however, will be much lower returns during big bull runs. A buyer today is getting a worse risk/reward profile, given that we are already well into an existing bear market.

JEPI has attracted absolutely incredible inflows since launch, as investors are gravitating to the combination of high yield and seemingly reasonable capital gains opportunities as well. And as JEPI is likely to continue outperforming for the duration of the current bear market, I expect it will remain a popular holding for months and perhaps years to come.

Over the longer term, however, the yield is coming from giving up capital gains that would otherwise be achieved from owning stocks without an upside cap. Only in an extended choppy or downward market would owning JEPI add much alpha versus simply owning the S&P 500 combined with either a cash or fixed income component.

If an investor can’t sleep well at night and is deciding between either reducing risk via a defensive ETF like JEPI or selling everything, the JEPI option would have better prospects. The worst thing an investor can do during a bear market is get out entirely, and thus forego all future profits as the market inevitably recovers. So, if it’s JEPI versus cash, I’d rather own JEPI. That said, I personally won’t be putting any of my funds here.

Systematic call-selling strategies don’t seem to provide much long-term alpha versus simply owning the index. And if you do want to take a defensive position, the time to enter them is at high valuations, not after we’ve already dropped sharply.

I fear that many investors will buy JEPI now to lower their risk, but then sell it during the next bull market once it invariably underperforms more aggressive ETFs on the way back up. JEPI can be a reasonable piece of a portfolio, but make sure you know what you own and don’t be surprised if it doesn’t keep up with the market once we turn the corner. There’s a real and substantial opportunity cost in return for the headline 10.6% dividend yield.