Any exchange-traded fund (ETF) generating a trailing-12-month yield of almost 7.7% and distributing monthly income will attract the attention of income-seeking investors. After all, invest enough in it, and you can live off the monthly passive income. But every investment has risk, and the JPMorgan Equity Premium Income ETF (JEPI 0.40%) is no different.
Here's what you need to know before investing in the fund.
What the JPMorgan Equity Premium Income ETF is
Launched in May 2020, this ETF aims to deliver monthly income to investors while capturing some of the upside of the S&P 500 index with low volatility. Management invests in two asset classes:
- At least 80% of assets go into an actively managed portfolio of equities using an investment process.
- Up to 20% of assets go in equity-linked notes (ELNs), selling out-of-the-money call options on the S&P 500 index.
The equity component of the ETF aims to capture the potential gains from the stock market and produce monthly income through dividends. Investing such a large share in equities means management should find a way to reduce volatility in the ETF's performance to hit its target goal. That comes from its investment in ELNs.
Image source: Getty Images.
When investors buy a call option on the S&P 500, they pay a premium for the right to buy the index at a specified price (the strike price) by an expiration date. It's typically purchased by investors who are bullish on the index. An S&P 500 call option is "in the money" when its strike price is below the current S&P 500 index. This is opposed to an "out of the money" option when the strike price is above the current S&P 500. You can think of in-the-money call option buyers as bulls and out-of-the-money call option buyers as very bullish -- they don't mind paying a premium and hope the strike price rises above the index level enough to offset the premium they paid.
This ETF effectively sells call options. So, it will pick up the premiums when the S&P 500 performance is negative over the period, and the index doesn't rise enough above the strike price.
As such, when the equity markets fall (usually taking the 80% of the ETF in equities with it), the ETF will still generate income from dividends and premiums from selling call options. This helps reduce the ETF's downside exposure to the S&P 500. Similarly, when the market has a strong month, the ELN/selling call options assets will lose money, and this will offset the gains in the 80% of the ETF held in equities.
Summing up, the ETF:
- Performs very well when the S&P 500 delivers moderately positive monthly returns -- the equity assets should do well, and the ETF can pick up premiums.
- Performs relatively well but could still be negative in a sharply negative month -- the equity assets will probably decline, but the ETF will pick up premiums.
- Underperforms in a sharply positive month -- the equity assets will appreciate, but selling call options will result in losing money on them.
How the strategy works in practice
As you can see below, the ETF has underperformed the S&P 500 on a total return basis (reinvesting dividends) since its inception. This level of performance is to be expected during a strong period for the index.
JEPI Total Return Level data by YCharts
However, note that it significantly outperformed the index during the bear market of 2022.
JEPI Total Return Level data by YCharts
Moreover, management is doing an excellent job of limiting the downside. The chart below shows the fund's monthly returns since its inception. The maximum drawdown was 6.4% in September 2022, when the S&P 500 dropped 9.6%. The ETF has only had one other month with a drawdown above 4% since inception.
Data source: JPMorgan. Chart by author.
How to think about investing in the fund
It's unlikely that this ETF will outperform in bull markets, even on a total return basis. As such, it's probably not an ETF for aggressive and bullish investors.
However, it will suit investors looking for a reliable monthly income and relatively low volatility. That said, investors should consider reinvesting the dividend because, as the chart below shows, the ETF would have significantly underperformed since inception without reinvesting dividends.
While there are risks -- the equity portfolio is actively managed, so there's an element of manager skill involved, and there's counterparty risk with ELNs in the event of a financial crash -- the ETF's performance indicates it can hit its aims. However, investors need to think about reinvesting at least some of the dividends in the ETF to see the full benefit of its strategy.
