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.