JEPI: Forget Capital Gains And Focus On High Income

Summary

• The JPMorgan Equity Premium Income ETF offers investors exposure to U.S. large cap stocks but with a significantly higher dividend yield, which currently sits at almost 11%.
• This high yield is achieved primarily through investments in equity-linked notes which generate income from call options premiums. It also invests in lower volatility stocks relative to the S&P 500.
• While this strategy means that the ETF will likely underperform in a strong S&P 500 bull market, a flat or declining market should see the JEPI strongly outperform.
• The use of derivatives and the limited track record suggest caution is warranted, but from a risk-reward perspective the ETF looks set to outperform, particularly for U.S. focused investors.

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The JPMorgan Equity Premium Income ETF (NYSEARCA:JEPI) offers investors exposure to U.S. large cap stocks but with a significantly higher dividend yield which is achieved largely by generating option premiums, and currently sits at almost 11%. For U.S. focused investors this ETF is highly likely to outperform given the weak returns that current S&P500 valuations imply. JEPI is an actively managed equity income ETF which holds derivatives and therefore is subject to more risks than regular long-only ETFs. As the ETF has only been around for two years, there is also limited historical data to test how it performs during different market conditions. However, on balance, I believe the fund is a buy, particularly for those looking to reduce volatility in their portfolio.

The JEPI ETF

The ETF seeks to provide the majority of the returns associated with the Fund's primary benchmark, the S&P500, while exposing investors to less risk through lower volatility and still offering high income. The ETF does this by creating a portfolio of equity securities with a lower volatility level than the S&P500 and also investing in equity-linked notes (ELNs). Under normal circumstances, the Fund invests at least 80% of its assets in equity securities, while ELNs comprise up to 20% of the portfolio and generate premiums from selling call options. The JEPI therefore employs a similar strategy as the XYLD, which I covered last month (see 'XYLD: A No-Brainer Alternative To The SPX'), and the two ETFs have performed very similarly since the JEPI's inception in June 2020.

JEPI Vs XYLD, Total Return (Bloomberg)

The main difference is that the JEPI employs an actively managed strategy, where fund managers use a bottom-up research process with stock selection based on our proprietary risk-adjusted stock ranks. This is another attractive feature of the ETF compared to the XYLD as it means lower exposure to expensive segments of the market such as Technology, as well as reduced concentration risk, as the top 10 securities represent just 18% of total holdings relative to 27% for the XYLD. Additionally, JEPI has a slightly lower expense ratio of 0.35% versus the XYLD's 0.6%.

JEPI Top Industry Holdings (Bloomberg)

XYLD Top Industry Holdings (Bloomberg)

Why The JEPI's Strategy Is Attractive Now

I particularly like the strategy of selling call options to generate income in the current market where U.S. stocks are overvalued. As I argued in 'SPX: Dip Buyers Beware' yesterday, the S&P500 remains priced for negative total returns over the coming years due to still-extreme valuations, and the 1.6% dividend yield is too low to compensate for the risk of capital loss. The main drawback of the JEPI and other equity income ETFs is that they underperform during bull markets. However, as we have seen in recent months, the high income generated allows them to outperform during times of equity market weakness.

S&P500 Valuation Vs Subsequent Returns (Bloomberg)

The ETF's current 30-day SEC yield, received through the combination of dividends on its stock holdings and option premium income, is a sizeable 10.7%, over 9pp higher than the S&P500 itself. This implied that for the JEPI to underperform the S&P500 we would need to the latter continue to post returns far above the growth of the economy, which is exhibiting trend nominal GDP and sales growth of around 4%. This means that S&P500 valuations would have to rise even further from current extremes for the index to outperform the JEPI. Even if this were the case, the JEPI's equity holdings would also likely rise strongly allowing the fund to generate strong returns.

Risks To Consider

The actively managed nature of the fund and the use of ELNs means that there are additional risks associated with the JEPI compared with the S&P500. There is no guarantee that the fund managers will be able to pick stocks with a lower level of volatility than the S&P500, and the fact that the ETF's equity holdings differ considerably to the S&P500 means that it could dramatically underperform its benchmark in the near term.

Perhaps the main risk, however, comes from the use of derivatives. As the ETF's prospectus explains, should the prices of the underlying instruments move in an unexpected manner, the Fund may not achieve the anticipated benefits of an investment in an ELN, and may realize losses, which could be significant and could include the Fund's entire principal investment. Investments in ELNs are also subject to liquidity risk, which may make them difficult to sell and value. A lack of liquidity may also cause the value of the ELN to decline. In addition, ELNs may exhibit price behavior that does not correlate with the underlying securities. The Fund's ELN investments are subject to the risk that issuers and/or counterparties will fail to make payments when due or default completely. Prices of the Fund's ELN investments may be adversely affected if any of the issuers or counterparties it is invested in are subject to an actual or perceived deterioration in their credit quality.

The fact that the ETF has only been in existence for two years also means that there is not much of a track record to assess how the fund performs during adverse cred market conditions as we saw during the Global Financial Crisis. For these reasons, I would recommend that investors hold JEPI as part of a broader diversified portfolio. Nonetheless, from a risk-reward perspective the ETF looks set to outperform, particularly for U.S. focused investors.

Disclosure: I/we have a beneficial short position in the shares of SPX either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.