This is my second article that delves into a growing universe of funds that may be of interest to dividend-growth (DG) investors because of their high yields.
I began a few weeks ago by examining the NASDAQ-100 Covered Call ETF (QYLD), which is an exchange-traded fund that generates lots of income by selling covered calls. Here is that article: Dividend Growth Stock of the Month for October 2021: 11.5% Yield; and here is the video based on that article, which is “going viral” on YouTube: In-Depth Review of QYLD (Covered Call ETF with 11.5% Dividend Yield, Pays Monthly).
The potential appeal of covered-call funds to a DG investor is high income.
High income can spur growth in a dividend-growth portfolio via dividend reinvestments, even if the ETF’s income itself does not grow or grows very slowly.
The subject of this article is JPMorgan Equity Income Premium ETF (JEPI). This fund has been the most-requested fund in the comments to the video noted above. JEPI has only existed since 2020, but its popularity has skyrocketed since being introduced. It surpassed $1 billion in AUM (assets under management) in its first year, and it has since passed the $2 B mark.
Let’s see what all the excitement is about.
JEPI in a Nutshell
Here’s a quick overview of JEPI. Following this bird’s-eye look, we’ll dig further and see how JEPI works.
Issuer: J. P. Morgan Asset Management
Active/passive: Active. This is the first ETF I have run across that does not follow an index. It is actively managed directly by its managers, like a mutual fund. In fact, it has a mutual-fund twin: JPMorgan Equity Premium Income I (JEPIX), which uses very similar strategies and is managed by the same management team. The mutual fund is designed for institutional and high-net-worth individual investors, with a minimum initial investment of $1 M. The ETF discussed herein trades on the open market and has no minimum investment.
Inception date: May 20, 2020
Principal goal: Provide current income while maintaining prospects for capital appreciation, at reduced volatility. Per JP Morgan, JEPI performed as designed during the twelve months ended June 30, 2021, capturing 74% of the S&P 500’s total return with only 63% of the index’s volatility.
Number of holdings: Around 100
Annual turnover: 145%
How it generates income: Combination of investing in U.S. large-cap stocks + selling options against them, thus realizing both stock dividends and option premiums.
Expense ratio: 0.35%
Home page for more details: JPMorgan Equity Premium Income ETF-ETF Shares
How JEPI Works
JEPI works through its (1) stock selection and (2) selling covered calls.
I discussed covered calls in my article on QYLD. To review, here are the important points about generating income through covered calls:
- When a covered-call writer (JEPI in our case) sells a call option (which is purchased by another investor), it earns a fee called a premium. The ETF turns those premiums into income for its shareholders.
- Covered call strategies inherently forfeit stock-price upside in exchange for current income. That is because call options give their buyers the right to take ownership of the stock – call it away – if a certain strike price is exceeded. So the option seller (JEPI) does not participate in price upside beyond the strike price, but it is still exposed to price downside, with moderate offset from the premiums collected.
- The call writer (JEPI) keeps the option premium whether or not the stock is called away. That’s how the premiums can be delivered to shareholders as income.
- The call is considered covered because the writer (JEPI) owns the stocks against which the calls are written.
Many call options expire without hitting the strike price, in which case the writer (JEPI) keeps both the stock and the premium. That’s the ideal scenario for a call writer: Low volatility. If the strike price isn’t hit during the term of the option contract, the call writer keeps all the shares and the premiums too.
That’s illustrated by this graphic from Morningstar. The numbers only pertain to the category, but give you some idea of price performance as a function of upward and downward market volatility.
Upside Capture Ratio measures the fund category’s performance in up-markets relative to an index, which I presume to be the S&P 500. The red 66 indicates that similar funds have captured 66% of the upside during periods of positive returns for the benchmark; in other words, they underperform, as would be expected.
The green 83 indicates that similar funds have outperformed in down periods by capturing only 83% of the index’s downward movement. The covered-call strategy, though its collection of premiums, helps such funds perform a little better than the index when the index is falling.
JEPI’s portfolio of assets consists of the stocks it owns plus exchange-linked notes (ELNs) that are used to execute the covered-call strategy.
Let’s look at the stocks first. This is sourced from Morningstar, because I want to show the stocks by themselves without mixing in the ELNs. Also, I am showing the top 20 holdings (instead of 10) because they are more equally weighted than one normally sees.
The total assets in the top 20 stocks amount to just 29% of the whole portfolio, which holds around 100 stocks altogether. Morningstar considers this to be a “large (cap) blend” portfolio. The blend is between growth and value styles.
The following display shows Morningstar’s quality metrics for the stock portfolio. 72% of the stocks have Wide or Narrow moat ratings (for QYLD it was 93%). The other grades are above average.
Remember that QYLD’s stocks came from the Nasdaq-100 index, so they were primarily tech and other high-growth stocks. JEPI’s stock holdings are not determined by an index. They are actively selected by JEPI’s managers. I was not able to determine their guidelines for JEPI’s picks, other than broad statements like these:
- (Mostly) large-cap U.S. stocks
- Diversified, low volatility equity portfolio
- Proprietary research process designed to identify over- and undervalued stocks with attractive risk/return characteristics
Now let’s look at JEPI’s portfolio as depicted by JPMorgan itself (source). Here we see that the top-10 holdings include the equity-linked notes (ELNs).
All of the holdings depicted as “SPX” are ELNs, and they are all larger percentages of the total assets than any stock. It is not necessary to understand the complexities of ELNs. Just know that it is through them that JEPI implements its covered-call strategy.
JEPI’s Performance vs. Its Objectives
We alluded to JEPI’s stated objectives earlier.
(1) Current income. JEPI doesn’t go out on a limb here – it’s obvious that it avoids saying “high” current income.
(2) Monthly distributions.
(3) Maintaining prospects for capital appreciation. Again, nothing specific.
(4) Reduced volatility.
Let’s see how JEPI has done against these objectives.
(1) Current income
Notice that JEPI’s yield is not shown prior to July, 2021, even though it was inaugurated a year earlier. That’s because it takes 12 months after introduction to be able to calculate an ETF’s yield. Yields on ETFs are calculated on TTM (trailing 12-month) basis, because their most recent dividend cannot be projected forward.
It looks like JEPI’s yield is settling in at around 7.5%, which is quite good. The reliability of that number is up in the air, because of JEPI’s short life.
At 7.5% average yield, an investor in JEPI would make back their entire initial investment in 13 or so years.
(2) Monthly distributions
This chart shows that JEPI has indeed made monthly distributions since inception.
As we see with ETF’s, the payments vary from month to month. This illustrates why it is not a good practice to project the most recent payout forward to calculate an ETF’s yield. While this is a small sample size, an eyeballed trend-line through those payments tilts down.
(3) Maintaining prospects for capital appreciation
This display shows JEPI’s price-only returns (orange) and total returns with dividends reinvested (purple).
For the same time period as the chart’s, the SPDR S&P 500 Trust ETF (SPY) – an ETF that covers the S&P 500 – had total returns (with dividends reinvested) of 47%. That means that JEPI produced 74% of SPY’s total returns.
(4) Reduced volatility
JEPI’s beta is 0.56 according to one source, which would make it nearly half as volatile as the S&P 500 (which JPMorgan uses as its benchmark).
I would say that JEPI has been hitting its vaguely-worded targets since its introduction.
- 7.5% yield is very good
- Pays monthly
- Total return has been 74% of the S&P 500 (both with dividends reinvested)
- Volatility has been a little over half the S&P 500
JEPI’s Total Return Performance
Even though JEPI is purchased by most investors more for its income than total return, most income investors don’t want to lose capital while they are generating income. Therefore, I feel that it is proper to examine JEPI’s total returns in comparison to some alternative investments.
In my previous article on QYLD, I noted that its sponsor came right out and said that a covered-call strategy sacrifices total return in exchange for high yield. JEPI says that it tries to “maintain prospects for capital appreciation.”
(1) S&P 500
We already mentioned this comparison earlier. Here’s the chart that shows it, beginning at the time of JEPI’s introduction last year. (In all charts, JEPI is the purple line.)
JEPI has produced 35% total returns compared to SPY’s 47% over this rather short timeframe. Stated another way, JEPI has produced 74% of SPY’s total returns.
Again, just to reinforce the reasons that a covered-call ETF produces lower total returns than a straight index when the index is generally rising:
- The covered-call strategy caps upside price participation but gives little protection against downside price movements.
- The ETF’s expense ratio is skimmed off the ETF’s cash every day, and active ETFs have higher expense ratios than simple index ETFs. SPY’s expense ratio is just 0.095% compared to JEPI’s 0.35%. Stated differently, JEPI’s expense ratio is more than 3 ½ SPY’s expense ratio.
(2) Covered-call ETF for S&P 500
Global-X (the company that produces QYLD) also offers a covered-call ETF where the stock index is the S&P 500. This ETF – Global-X S&P 500 Covered Call ETF (XYLD) – is attracting a lot of money from investors. It has a current yield of about 6.3%.
Here is the total-return comparison to JEPI with dividends reinvested:
JEPI has bested XYLD by about 3 percentage points. The differences would come from the blended effects of different stock portfolios, the way the covered-call strategy is being deployed by each ETF, and different expense ratios.
(3) Closed-end fund
Closed-end funds have been offering active portfolio strategies, designed mainly to produce high income, for decades before ETFs existed. There is not space here to get into how covered-call CEFs operate. Suffice it to say, like the newer covered-call ETFs, they are designed to “convert” total returns into income for investors.
For example, consider Nuveen S&P 500 Buy-Write Income Fund (BXMX). This short description from Nuveen lays out its objectives:
The Fund seeks attractive total return with less volatility than the S&P 500 Index by investing in an equity portfolio that seeks to substantially replicate the price movements of the S&P 500 Index and by selling index call options covering approximately 100% of the Fund’s equity portfolio value with a goal of enhancing the portfolio’s risk-adjusted returns.
Here are quick facts about BXMX:
- Introduced in 2004.
- Yields about 6%.
- Distributes quarterly.
- Sells call options on 99-100% of the stock portfolio, which consists of around 270 stocks.
- Expense ratio = 0.91%.
- Distributions come from regular interest and dividends, realized capital gains, and possibly returns of capital representing unrealized capital appreciation.
Here is the total return comparison since JEPI was introduced.
As you can see, Nuveen’s CEF – based on a similar strategy to JEPI’s approach – has outperformed JEPI by 12 percentage points. Stated another way, JEPI has returned 72% of BXMX’s total return with dividends reinvested.
Here is a summary of the funds discussed in this article:
What are the takeaways?
- As with all covered-call funds, JEPI forfeits a portion of total return in exchange for generating a higher yield for its shareholders.
- That said, JEPI’s income is significant at around 7.5%.
- JEPI pays monthly, which some investors will find attractive. The payments vary significantly month-to-month.
- JEPI was just launched in May of 2020, so all conclusions are based on a small sample size. And since the fund is operated directly, there is no underlying index that could be back-tested to get a better handle on likely performance.
It is hard to value an ETF, because of all the moving parts. One way is to compare the fund’s current yield to its historic average yield. I plotted both JEPI’s price (orange line) and current yield (purple line) since inception here:
I drew the yellow stripe to estimate the average yield just by eyeball. The stripe would suggest that JEPI’s average yield has been about 7.8%, which would make it slightly overvalued right now with its current yield of 7.5%. Its current yield (7.5%) is about the lowest yield I would buy JEPI at.
Comparing Covered-Call ETFs and CEFs
I now have done two articles on popular covered-call ETFs: QYLD and JEPI. In the course of the articles, I have suggested possible alternatives for investors to consider, including two closed-end funds (CEFs) that use similar strategies, as well as the standard S&P 500 and Nasdaq-100 indexes.
This section pulls the major points together to compare and contrast these different investments.
The task is complicated by timeframes. Some funds have existed for many years, while others – such as this JEPI – have barely been around for a year. For that reason, in the chart below, I used 5-year annual returns for comparisons across funds. That leaves JEPI with incomplete information.
The funds are arranged by their date of launch.
Note that SPY and QQQ are straight indexes, not covered-call funds. They represent the S&P 500 and Nasdaq-100 indexes, respectively. I colored them green to distinguish them as “conventional” ETFs. (They also happen to be the two oldest in the table, so they are at the top.) I include them to illustrate the trade-offs when you sacrifice total return for generating very high yields.
I do not make recommendations or give advice. But if it were me, and I were interested in a high-yield covered-call fund that still delivers decent total returns, I would probably select QYLD from that list. Of course, QYLD’s performance has been spurred by the run-up in tech stocks, and there is zero guarantee that performance will continue to shine.
JEPI’s short history would disqualify it for me. I have always required at least 5 years of operating history to select any investment, and I see no reason to depart from that practice with so many alternatives available.
Taxation: At least part of the distributions by covered call funds are usually not qualified dividends under tax law. The tax implications of this are too complex to cover here. The fund will send you a notice at the end of the year about how the distributions are classified for tax purposes. Note that “return of capital” lowers your cost basis and delays taxes until you sell the shares. Many investors consider this to be a feature, not a bug. Fund provider Global X advises that “Particularly tax-sensitive investors may want to consider holding covered call ETFs in a tax-advantaged account or consult with a tax accountant prior to investing.”
A final note on risk: Making good investment choices always depends on goals. Covered-call funds “trade” total returns over time for more current income. That is baked into their design. They will usually underperform the stock portfolios on which they are based.
This is not a recommendation to buy, hold, sell, trim, or add to any of the funds discussed. Any investment requires your own due diligence. Always be sure to match your stock and fund picks to your personal financial goals.
— Dave Van KnappWe’re Putting $2,000 / Month into These Stocks
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