The Federal Reserve has been raising rates at a sharp pace since March of 2022 breathing new life into bonds. Historically, bonds have generally underperformed stocks, but new interest rates are providing easy returns in the form of treasuries, bonds, money market funds, certificates of deposits, and savings accounts. But after the surge in options trading, with the Options Clearing Corporation reporting options trade volume more than doubling from 2019 to 2021, and remaining strong through 2022, some traders and investors might not be ready to settle for fixed income just yet. Hence, the chatter on Reddit/Twitter/Facebook regarding J.P. Morgan‘s premium income ETF (JEPI). So how is JEPI different from popular index ETFs?
TLDR (too long didn’t read): JEPI is an actively managed ETF that holds stocks selected by the portfolio managers and writes out-of-the-money (OTM) call options on the S&P 500 index. Volatility should be muted compared to the overall market but at the expense of growth.
The Technicals
JEPI is an Exchange-Traded Fund, an ETF, which is a type of pooled investment security that is similar to a mutual fund but can be traded like a stock (while mutual fund shares are purchased or sold at the end of the trading day, stocks and ETFs are traded in real-time). ETFs can be actively or passively managed, but the most common ETFs are popular for having very low expense ratios due to being passively managed. Many ETFs follow an index, such as the DOW Jones Industrial Average (DJIA), or a sector or commodity.
As of the time of writing, JEPI has net expenses at 0.35%, a 12-month rolling dividend yield at 9.8%, assets under management (AUM) valued at $29 billion, and a net asset value (NAV) of $55.15/share with a premium of 0.05%. JEPI is actively managed.
The nitty-gritty of exactly which options are held by JEPI at any one time is available to the public via J.P. Morgan’s Asset Management website. As of the time of writing, JEPI has 136 holdings, ranging from consumer discretionary company shares such as Amazon (AMZN), to technology company shares such as Adobe (ADBE) and Microsoft (MSFT), to health care company shares such as Eli Lilly (LLY), and even industrial company shares such as Eaton Corp (ETN).
Coming back to the original question of trying to understand what JEPI is and how it is unique compared to most other funds. So far we can see that it is actively managed and holds a wide array of company shares (limited to U.S. large-cap). It does not track any one index, sector, or commodity. The portfolio managers, aka the investment advisors, are picking stocks they like. What really makes JEPI stand out is the synthetic holdings. JEPI currently has 16 synthetic positions in SPX, the Standard & Poor’s 500 index* option. And that is what makes JEPI unique.
* The Standard & Poor’s 500 index, aka the S&P 500, is a stock market index tracking the stock performance of 500 of the largest companies listed on stock exchanges in the United States, as selected by a committee.
JEPI is an actively managed ETF that holds stocks selected by the portfolio managers and sells out-of-the-money (OTM) call options on the S&P 500 index.
The shares held should increase in value over time (capital appreciation) and pay dividends, while the options contracts should expire, or be able to be bought back at a cheaper price, from when they were sold providing JEPI investors a monthly income.
The Good
The strengths associated with JEPI are:
- Capital appreciation (increased share value)
- Yield (dividends)
- Cash flow (option’s premium)
“Should” does not equal “will”. So what happens if things don’t go according to plan?
JEPI holds shares that managers and investors hope will increase in value, and also holds short call options on the S&P 500 which managers and investors hope will decrease in value. This is a defensive strategy that works best when the stock market is not roaring up. If the selected shares can outperform while the general stock market stagnates then the plan has gone accordingly, meaning this ETF is great in times of bear markets or when markets are flat.
The Federal Reserve has been raising rates, which threatens to dampen stock performance. This may be an optimal time to invest in JEPI. But what happens if the market continues to go up? If the shares selected by the managers don’t outperform the market, investors will still make a profit, but not as much as if they had bought other shares (opportunity cost). If the stocks selected by the managers go down in value, then investors lose out. If the S&P 500 increases quickly, such as is common in a bull market, then the ETF will not increase as much as its underlying shares since the SPX options will lose money.
The Not Good
The potential pitfalls associated with JEPI are:
- The company shares selected by the managers don’t outperform the rest of the market (negative alpha).
- The S&P 500 increases faster than the managers expected resulting in the OTM SPX option contracts becoming in-the-money (ITM) before maturity.
The risks don’t make JEPI a bad investment. In most cases, JEPI is a sound investment. Stock market investing was booming during the COVID pandemic and options trading reached new levels of popularity. The trend during those years was quick growth. If investors are looking at JEPI for quick growth, as something that can outperform the popular S&P 500 ETFs, they will most likely be disappointed as that is not what this fund is designed for. Beware: This is not for the WallStreetBets apes.
What It All Means
In a nutshell, this ETF is designed to provide investors with an investable product that has cash flow and low volatility (low beta). Low volatility means fewer losses and fewer gains. Losses in share value are offset by profitable options trades, and gains in share value are offset by unprofitable options trades. Losses from options trades are offset by increased share values and gains from options trades are offset by decreases in share values. This is stated clearly on the JEPI product page: “JPMorgan Equity Premium Income ETF seeks to deliver monthly distributable income and equity market exposure with less volatility.” Low volatility is typical of wealth management strategies to provide steady and predictable revenue for wealthy customers.
Low volatility and monthly distributions sound great, so what is the catch? J.P. Morgan & Co. (referred to as the “House of Morgan”)has been in operation since 1871 and is now a subsidiary of JPMorgan Chase & Co., the largest bank in the United States and the world’s largest bank by market capitalization as of 2023. The portfolio managers are expected to be highly experienced, extremely intelligent, educated, and ultimately prudent in their stock selection and option contracts management. The strategy employed via JEPI is logical and not uncommon among active investors. The caveat with this strategy is that the options contracts are always for SPX and the shares are U.S. large-cap stocks. They are not replicating the S&P 500 index and then selling OMT SPX call options. There is the possibility that SPX will increase in value, hurting the options position held by JEPI, and the stocks selected by the portfolio managers will decrease in value. This double whammy would undermine the whole purpose of investing in this fund. On top of that, investors will still pay the net expense of 0.35%. Put simply, the portfolio managers are taking on a large responsibility. The silver lining is that the managers may be willing to waive or reimburse expense fees in certain circumstances. As noted in the fund page’s performance and fees section, the expense fees were waived or reimbursed before: “Prior to the implementation of a new management agreement on 11/1/19, performance for some periods may have reflected the waiver of all or a portion of the Funds’ advisory or administrative fees and/or reimbursement of other expenses by the adviser. Without these waivers or reimbursements, performance would have been lower.”
Performance
All this is not to say JEPI is a low-performing ETF. The JEPI fund inception date was May 05, 2020, and since then has increased its share price by 7.77%. During that time the popular S&P 500 ETF SPY increased its share price by 45.48% and the other very popular S&P 500 ETF VOO increased its share price by 45.98%. JEPI has added cash flow with its options sales. Reinvesting monthly dividends would mean JEPI grew 48.69%, while SPY grew 57.27% and VOO grew 57.57%.
The stock chart for JEPI is noticeably flatter compared to SPY and VOO adding support to the fund’s claims of lower volatility. This claim is further supported by the fund having a maximum drawdown (dip) of 13.12% compared to SPY’s drawdown of 23.87% (both funds share the same drawdown valley date, drawdown peak date, and drawdown duration). So far, JEPI has done as advertised.
The Conclusion
In conclusion, JEPI is an actively managed ETF involving stocks and options, providing cash flow and reduced volatility. It is not for everyone and comes with both risks as well as benefits.
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