The JPMorgan Equity Premium Income ETF's (JEPI 0.12%) trailing 7.6% dividend yield is eye-catching enough to attract investors looking for monthly income. But just how risky is it? Here's what you need to know before you buy it.
The JPMorgan Equity Premium Income ETF
The exchange-traded fund (ETF) aims to generate sustainable monthly income for investors while having the potential for capital appreciation. Its managers also seek to achieve lower volatility than the S&P 500 Index by investing in equities and equity-linked notes (ELNs).
The strategy of the ETF is as follows:
- Invest at least 80% of net assets in actively managed equities
- Invest up to 20% of net assets in ELNs, selling call options exposed to the S&P 500 Index
This strategy aims to capture the market's upside potential by holding equities and limit the ETF's downside exposure to a falling market by investing in selling out-of-the-money call options. I'll discuss the strategy in more detail in a moment, including its pluses and minuses. But first, here's a look at its track record.
Image source: Getty Images.
The chart below shows the ETF's performance compared to the S&P 500 since its inception. As you can see, the ETF's performance in terms of capital appreciation is underwhelming. However, the returns are impressive when its substantial monthly dividends are reinvested (total return price).
While some investors may not like the underperformance compared to the S&P 500 and the S&P 500 with dividends reinvested (total return price), note that the fund doesn't aim to beat the S&P 500.
In addition, the ETF has a good record of limiting downsides. The chart below shows the fund's monthly returns since its inception. The maximum drawdown was 6.43% in September 2022, with only one other month with a drawdown above 4%.
Data source: JPMorgan. Chart by author.
Actively managed equities
Interestingly, the ETF's managers don't invest based on dividends, as "securities are not selected based on anticipated dividend payments," according to the ETF's literature. Instead, they use a good old-fashioned "buy low and sell high" stock picking approach. The managers also use research models to select and rank stocks to produce a portfolio of equities with lower volatility than the S&P 500 index.
This is not a passively managed ETF or an index hugger. Simply put, the equities in the portfolio expose the investor to the downside and upside risk of the managers' skills.
Selling call options
A call option is the right to buy a stock, or in this case, the S&P 500 Index, at a specific price up to an expiration date. Investors pay a premium for this right, paid to the issuer. As such, it's bought by investors who want exposure to a rising price. An "in the money" call option is one priced below the current price of the stock or index. An "out of the money" call option is one priced above the current price of the stock or index.
Image source: Getty Images.
Purely by way of example, if you think a stock is going to $20 but it's currently priced at $15, then an option priced at $13 is "in the money" (although it might cost you a $6 premium to buy it). Alternatively, a call option priced at $17 is "out of the money" (although it might cost you a $1 premium to buy it).
If the stock goes to $20, then the "out of the money" option will make you more money ($18 cost and $20 sale value) compared to the "in the money" option ($19 cost and $20 sale value).
As buying S&P 500 call options exposes investors to an upside of an increase in the S&P 500 Index, it follows that selling them (a strategy the ETF follows) exposes investors to the downside of an increase in the S&P 500. However, as the ETF has at least 80% of its equities assets, it will benefit from a positive move in the S&P 500 Index.
Alternatively, if the S&P 500 drops, the ETF will benefit from the premium, as investors will not realize the option.
Image source: Getty Images.
An ETF to buy?
It's an interesting strategy, but not without some risk. ELNs are structured products, so there's always the concern that the financial company issuing them might be unable to meet the obligations. In addition, the strategy tends to cap returns in surging market conditions while not ultimately protecting against the downside.
Still, as a way to secure monthly income, the ETF is worth considering for investors interested in consistent income.