JPMorgan Equity Premium Income ETF JEPI

J.P. Morgan Equity Premium income takes a nuanced approach to covered calls that delivers high income while reducing downside risk. This fund’s incremental improvements on a basic covered-call strategy make it a solid option in the derivative income Morningstar Category, though income from covered calls generally isn’t tax-efficient.

This fund owns a defensive equity portfolio that targets a low beta to the S&P 500 while systematically selling one-month call options on the index. The manager trades the options in weekly tranches to reduce path dependency and targets 30-delta out-of-the-money calls to capture a modest amount of the index’s upside in addition to collecting the options premium. The fund uses equity-linked notes, or ELNs, that mimic the profits from writing call options instead of shorting the options themselves. ELNs carry additional counterparty risk, but the team at J.P. Morgan diversifies counterparties and only transacts with global financial institutions that pass their regular counterparty risk monitoring. Tax treatment of ELNs is often favorable for capital gains on equity returns but can be disadvantageous for options profits. Investors in the highest tax brackets may prefer to pick a more tax-aware fund. However, the fund’s total distribution often ranks in the top quintile of its category, which should keep its aftertax income attractive for investors in lower tax brackets.

In general, covered-call funds have not been the best buy-and-hold investments for investors with a longer time horizon. The equity portfolio’s upside is capped, and the downside remains exposed to significant drawdowns, which will likely erode an investor’s long-term total returns. Even for investors with high-income needs, there may be more-tax-efficient options available. However, covered-call funds provide a simpler way to outsource this task and can alleviate problems that come with self-implementation.

This fund’s high payouts, reduced path dependency, and lower-risk equity portfolio work to its advantage compared with category rivals. Its underlying index, the S&P 500, is also a reasonable choice for a covered-call strategy. The S&P 500 has enough upside and options liquidity to provide harvestable call premiums, while not being overly volatile like some of the indexes used by category peers.

This strategy uses the equity and options sleeves to reduce losses during index drawdowns. Writing call options in down markets can benefit the fund in two ways. First, the premium collected can offset losses to an extent, giving the fund an advantage over the index itself. Second, implied volatility increases during sharp drawdowns, which often translates to higher call premiums. The equity portfolio is also constructed more defensively than the index. It beat the index significantly during the late 2018 selloff and 2022 market meltdown. Shorting call options caps the fund’s upside relative to the S&P 500, but it still kept up with category peers and the category index during recent market rallies. These features contributed to the fund outperforming both the category index and category average since its inception.

It earns a Process Pillar rating of Above Average.

This fund combines a systematic approach to selling call options on the S&P 500 with a low-beta equity portfolio. The defensive equity sleeve targets a 0.8 beta to the S&P 500, which results in a beta of 0.6 for the total portfolio with the options overlay. J.P. Morgan industry analysts generate earnings forecasts and valuation rankings for each stock in a broad universe. The manager uses both their quantitative forecasts, to drive selections and weightings, and their qualitative subject matter expertise to contextualize the source of equity risk and market events. No sector can account for more than 17.5% of the portfolio, and no single position can exceed 1.5%, which prevents any single sector or stock from having an outsize impact on volatility.

For the options sleeve, the manager writes one-month, 30-delta out-of-the-money calls, whose strike prices historically fluctuated around 2% above the index price. The options’ strike prices tend to increase further out of the money during periods of heightened volatility, typically during market downturns. The manager staggers the calls in weekly tranches to alleviate the market impact from their options trades and diversify the strike price and call premiums.

The fund packages its calls into an ELN instead of directly shorting the call options. This turns call premiums, which are taxed as capital gains, into interest income, which is taxed as ordinary income. The fund loses the ability to recognize a portion of the premiums as long-term capital gains, whose tax rate is more favorable. However, its higher-than-average payout should compensate for this tax treatment for most investors in lower tax brackets. In addition, this structure avoids the straddle or mixed-straddle tax identification that most peers have. This often results in gains on the equity sleeve being treated as short-term capital gains and precludes equity dividends from a reduced tax rate for qualified dividends. Depending on market conditions, some peers may also have to distribute part of their premiums as return of capital, which is not taxable income but reduces an investor’s cost basis in the fund.

The use of ELNs invites additional counterparty risk. The fund invests around 15% of its assets in ELNs, below the 20% regulatory cap, and spreads its ELNs across four to five issuers to stay under the 5% issuer-level cap. The management team is only allowed to transact with large global financial institutions, typically global systematically important banks, or G-SIBs. They purchase ELNs from issuers offering the best income through a competitive auction process, which should tame the commission spread.

Covered calls effectively cash in on a fixed rate of the index’s upside. These payouts help cushion the strategy’s performance during downturns and add value during sideways markets when the index does not breach its strike price. The defensive equity sleeve should also have shallower drawdowns. However, selling call options caps the strategy’s upside roughly at the strike price of the call plus its premiums. This detracts from performance in market rallies or when lower implied volatility damps call premiums. In addition, its defensive equity sleeve might not keep up with the S&P 500 during rallies. This can cause the fund to underperform a traditional covered-call strategy that simply holds the S&P 500 stocks during up-markets. Staggering the options in weekly tranches can also cause short-term deviations from expectations based on monthly index performance, but this should smooth out over the long run.

This fund’s defensive approach to the equity sleeve tends to underweight mega-cap names and high-growth sectors relative to the S&P 500. It also excludes a sizable number of larger index constituents that it considers too expensive or volatile, instead allocating to smaller companies with reasonable valuations. So far, the equity portfolio has provided protection in most major downturns since the fund’s 2018 inception while moderately keeping up during rallies.

Equity dividends make up a minimal portion of the fund’s payout as the manager doesn’t specifically target dividend-payers. The fund’s annual yield has hovered between 8% and 12% since inception, partly thanks to the recent high-volatility and high-interest-rate environment that pushed premiums up. Income expectations will likely fall lower in the long run but should continue ranking among the highest in the category.

The team earns an Above Average People rating.

Lead portfolio manager and strategy architect Hamilton Reiner joined the firm in 2009 and has three decades of experience in derivatives markets. Prior to joining J.P. Morgan, Reiner held senior positions across Wall Street at Barclays Capital, Lehman Brothers, and Deutsche Bank, and he spent the first 10 years of his career at O’Connor and Associates, an options specialist firm. He is supported by two junior portfolio managers who joined from the ranks of the equity analyst team, and a strong supporting institutional framework at J.P. Morgan.

Raffaele Zingone runs the equity sleeve on this fund, leveraging more than three decades of his equity investing experience. The equity portfolio is the clone of a J.P. Morgan managed volatility separate account that he has long maintained with positive results. He utilizes quantitative forecasts and qualitative industry knowledge from J.P. Morgan’s broad roster of 20-plus equity analysts who average 21 years of industry experience. Consistent with groups this size, there has been modest turnover on the analyst team. Reiner and Zingone both invest more than $1 million alongside investors in both the ETF and mutual vehicles combined, signaling a strong alignment of interest between management and shareholders.

As of 2022, this investment stalwart manages more than USD 2.5 trillion in AUM. Composed of various global cohorts and diverse asset classes, the firm has more tightly integrated its capabilities in recent years, notably through the development of proprietary analytical and risk systems. Investment teams are robustly staffed and helmed by seasoned contributors. The firm’s strategies tend to produce reliable portfolios, and several flagship offerings are Morningstar Medalists. Manager incentives align with fundholders'; compensation reflects longer-term performance factors, and portfolio managers invest in the firm’s strategies as part of their compensation plans.

The firm’s funds tend to be well-priced, but they aren’t as competitive as many highly regarded peers of similar scale. Recent product launches include thematic and single-country strategies, both of which carry the potential for volatile performance and flows, along with misuse by investors. The firm remains intrepid when it comes to developing an environmental, social, and governance-focused framework and continues to move into other areas such as direct indexing through its 55iP acquisition and China through its joint venture, but these complicated initiatives take time to assess any real and lasting effect.

The fund has outperformed the S&P 500 during major downturns. The I share class beat the S&P 500 by 5.49 and 14.23 percentage points during the selloff in the last quarter of 2018 and the 2022 market meltdown, respectively. On top of the buffer from its call premiums, the fund’s defensive equity sleeve also cushioned the fund. For instance, the equity sleeve outpaced the index by 10.88 percentage points in 2022, an impressive feat even after accounting for its lower beta exposure.

The fund has lagged the S&P 500 during market rallies given its short-call position and defensive equity sleeve. The I share class trailed the index by 21.3 percentage points between March 23, 2020, and Dec. 31, 2020. Similarly, it underperformed the index by 5.27 percentage points during the moderate but persistent growth of the first eight months of 2021.

Nonetheless, the fund provided better performance than its average category peer and category index, the CBOE S&P 500 BuyWrite Index, during these periods. When markets rallied between late March 2020 and December 2020, it outperformed both the category average and category index by 0.21 and 3.36 percentage points, respectively. It generally provided better downside protection than these two benchmarks, save for March 2020 when implied volatility suddenly spiked then dropped.

Overall, this fund’s performance has been solid. From its September 2018 inception through August 2023, the I share class outpaced the category average and index by 3.2 and 4.9 percentage points, respectively.

Based on our assessment of the fund’s People, Process, and Parent Pillars in the context of these expenses, we think this share class will be able to deliver positive alpha relative to the category benchmark index, explaining its Morningstar Medalist Rating of Bronze.