JEPI: Forget The Hype, It Is Good But Not Great (2024)

I'm that guy. That guy who looks at what everyone else seems to consider a "no-brainer" investment, and my first reaction is "are they sure?" To me, investment management is risk management, period. First, you avoid big loss, then you make as much as you possibly can, in terms of sustained total return (appreciation plus income).

In 30 years of professional investing, that simple 2-part rule has not made me the highest returner in the crowd, but it has kept me out of big trouble. And since the investment industry and media are filled with more hype, distractions, bravado and testosterone than ever, I find that the closest I can get to being comfortable as an investor is to keep going back to that simple guideline.

That means that whenever I spot a market area, prevailing narrative or individual security (ETF or stock) that has clearly entered that phase with investors where it is "too great to fail," I do what I've always done: go looking for ways to bust the myth (heck, its right in my SA bio: dissect the market, bust common myths and simplify the investment process for his audience).

And that brings me to what is arguably the most popular ETF with Seeking Alpha readers (there's another I'd consider in the top 2, but I'll save that for another article). It is the JPMorgan Equity Premium Income ETF (NYSEARCA:JEPI)? There have already been 7 articles written about it on this platform in 2024, while most ETFs don't get that much attention in a year. I intend to make this my last commentary involving JEPI and covered call ETFs for a while.

It has been an area of intrigue for me, and I have drawn some conclusions, both about the players in that space and about investor use of covered call ETFs in general. Frankly, the more I started to research, write about, speak about (on the SA Investing Experts podcast) and use them with my own money, the more my opinions about buy-write ETFs gelled. That's how investment research should work - it's a process, not a cheerleading contest.

So, here is are my latest assessment on JEPI, a couple of its peers and how I think investors should approach them going forward. Because the past few years have experienced an evolution in markets that is just starting to show up in performance of many ETF types, including covered call funds.

Covered call ETFs have become Wall Street's "clown car"

No, I'm not talking about anyone that invests in them. I mean the flood of new products that ETF issuers have rustled up and gone to market with as fast as they could, hoping to get a piece of the proverbial land rush, once they saw how popular JEPI became. The clown car analogy is a small automobile, stuffed with more covered call ETF products than the marketplace needs. But just as with many past episodes of this never-ending story, we see the industry go from a drip to a firehose in no time. It rarely ends well.

This is classic Wall Street: take a good idea, then overdue it until many investors fall in love with them, more out of emotion and pride, and less so due to really understanding how these products should be used within their larger portfolio. In the case of covered call ETFs, I've seen too many comments about them to conclude that investors understand that they are trading off a ton of upside potential in exchange for not nearly enough downside protection.

I always ask myself "what could go horribly wrong" and in the case of covered calls, we've seen it, but many investors are unfazed. Specifically, sharp stock market declines that do not immediately reverse themselves. The two that have occurred since JEPI and many others debuted were a 33% drop in the S&P 500 index in 5 weeks (Q1 2020) and the 2022 drop of 25% from peak to trough, which was recovered in under a year. That tends to breed overconfidence.

So, what could go wrong? It all has to do with the fact that the income from covered call writing is paid once a month in most cases. JEPI's 12-month yield ran as high as about 12%. Now it is closer to 8%. That's still a solid "income level, but that 8-12% is getting closer to looking like the upside cap in total return in these types of vehicles. Why? 2 reasons:

1. They don't allow investors to participate in enough upside because the calls are struck too close to the money

2. Any sharp market drop is likely to hit these ETFs similarly, because investors are only "accruing" that income at perhaps 0.7%-1.0% per month. So what if something like the 2020 crunch (charted below) occurs (not due to another pandemic, hopefully, but there are plenty of other possible sources of market stress out there)? You drop 30% or so, and that 1% per month is a long climb back to just break even.

Investors have been conditioned to rely on the market always snapping right back. That's what 15 years of easy money policies will do. But IF... and I say IF because I'm managing risk, not assuming any outcome here... the stock market does like that lady in the old TV commercial -- it's fallen and it can't get up -- investors will be stuck in a situation usually reserved for holders of busted junk bonds. That is, if you have a bond that would mature at $100 in some number of years, but its credit rating is slashed and its yield spikes, that bond might sell for $50 on the dollar, as an example. Sure, you might be getting, let's say $8 a year in income from the bond, but it could be many years until your principal is recovered, if at all.

Can the stock market ever go 5 years without making any money? More often than you think

Above you see 5-year rolling returns (monthly moving window) since the inception of the SPDR S&P 500 Trust ETF (SPY). Notice how often its total return (not annualized) is near zero or a bit below or above it for 5 years stretches. Welcome to my world, or at least the one I've managed money through. I started managing my first mutual fund on August 16, 2008, right before the markets went from bad to very, very, very bad! And I was a private client advisor during the dot-com bubble.

The 7 stages of financial grief: coming to a market near you?

So unless human nature has totally changed, here's how it might go the next time covered call investors get struck by a sharp market decline and see JEPI or a similar ETF down 25-35% quickly. Consider this like the 7 stages of grief, except about your money.

1. Rough market, eh? But I'm a long-term investor, so having 1/3 less than I did a little while ago is fine. After all, I still have all that covered call income, and that's all I care about.

2. Hey, this market is not really going anywhere. Well, it will get better. It always does. BTD/number go up, eh?

3. I know my covered call ETF is still down 30% from the peak 6 months ago, but I have received 5% in income since then, so I'm really only down 25%.

4. The market keeps rallying, then heading lower. Gotta keep the faith, right? Can't time the market, its time IN the market. In the long run, it always goes up.

5. I'm starting to wonder if the "long run" is going to be longer than my patience lasts. And I hear that a lot of those covered call ETFs are shutting down now, since so many people bailed on them.

6. OK, it has been a couple of years and I'm still way underwater on this thing. Maybe I should start thinking about another form of "safe income" because that what I thought this covered call ETF was.

7. I looked back at my buy on this ETF and now I'm saying that word again. Except this time, its spelled differently: B-Y-E. I sold my covered call ETF. Never going to even mention those words again. Those things are loser investments.

Risk management meets informed investing

Investors should feel free to disagree with everything I wrote above. However, the one thing none of us can deny is that investment history is littered with exactly this type of scenario. I've lived it as an overseer of "other people's money." I have forever been a risk manager first, always willing to give up "potential" return to avoid life-changing outcomes like those that occur when a popular investment is misunderstood by the masses. I didn't say all investors, just too many to make me comfortable that the 7 steps above will not play out at some point during the rest of this decade.

JEPI is now well over $30 billion in AUM. As I've said before, it is a solid fund for what it is built to do. I remain a bit skeptical of the fund's limited transparency, as they don't reveal enough detail for me when it comes to the specifics of the private placement arrangements they use instead of their peers, which show you exactly which public market options they own every day. I like being able to follow along, since I have experience running portfolios like that from my client days, and if I'm going to outsource it to an ETF, I want to look at all the underlying holdings.

I called JP Morgan Asset Management on this a while back and they were very straightforward with me. I get that the fund's size forces them to skip past the public markets and arrange private contracts to generate covered call income, and that those contacts are with brand name counterparties. But I invested through Bear Stearns, Lehman etc. So let's just say I haven't seen everything, but I've seen enough to think of a fund as good, not great if the transparency isn't there. Again, these are my views, and I do not for a moment expect any other investor to share them. But with all the nice vibes around JEPI and this entire segment of the ETF world, this seems the best time to try to at least convey what I've seen in situations that smell a bit like this. Not the covered call part, the exuberance part.

JEPI: asset flows peaked, then performance did

JEPI's asset-gathering fiesta peaked in January of 2023 at an astounding $2.4 billion in that single month. Flows continued solidly but at a declining rate after that. So a look at performance since that time and over other relevant periods versus a couple of alternative ways to pursue a similar objective to JEPI may be helpful.

First, here is JEPI versus a pair of peers that use covered calls, and like JEPI don't completely cover their stock portfolios at the money with those options. The ETF products that do that are even more dangerous, since they offer near-zero upside. JEPI and these others offer some.

What I see here is a virtual tie since their common inception date in late 2020. JEPI was a slightly smoother ride during part of this period, but they ended up around the same place. That's worth noting because when you look at their asset-gathering pace (below), it is a head scratcher.

JEPI has run up to $31 billion or so, while the others that performed in line have grown, but not amounted to the juggernaut that JEPI has. Is it marketing? Yes, in part. But there may also be some group-think/perceived safety in numbers going on there. And part of my concern about any "alternative" ETF that grows to that size is that they will be less effective than when they were smaller and more nimble. I just don't think that specialty ETFs like JEPI operate as well at $30 billion as they do at, say, $5 billion or even $10 billion perhaps.

And that's what we see here. JEPI's 6-month rolling returns have hit a slump. Maybe it is just a passing phase. Or, maybe it is the constraints of size. We won't know for a while, and I am NOT a JEPI hater. I am JEPI realist, because I've seen this movie before, and it usually ends with a segment of disappointed investors. In this case, it is not simply a JEPI story, but one that will impact the rest of the peer group if the market gets rough. All I'm saying is that investors should be eyes wide open on this type of market climate, as opposed to having blind faith "because it did so well" in 2021 or 2022 or whatever.

Finally, a table (below) I created to show that JEPI and its mutual fund clone JEPIX have underperformed those 2 peers on a 6-month trailing total return basis for 10 consecutive periods. And, by noticeable margins. The bottom line here is that for one fund to be at $30 billion and the others, who have performed similarly over time and much better recently, this is an investment oddity. Money tends to follow performance, but that has not yet happened here.

Final thoughts on JEPI and the covered call ETF mania

1. Covered call writing is a very solid income/total return strategy for the modern market climate, but it has to be used with full understanding of the variety of market outcomes that can impact it. Just looking back a few years is not enough. In the case of these ETF products, none go back far enough to stress-test them through the more sustainable down markets of our lifetime.

2. You have to really know what you are doing in terms of reward/risk trade-off. Too many investors buy and hope blindly, not realizing that the way most covered call ETFs are structured, upside tops out with the call premium, but there's no downside cap. A very poor trade-off in bear markets, and in markets that shoot up in price in days or weeks, but your covered call income is arriving once a month, and does not accrete.

T-bills are still yielding near 5%, so that's about 3/5 of what JEPI is. To me, I'll be demanding higher yield, more downside protection and more upside potential, or some combination thereof, before I go too far with these. I no longer own any positions in covered call ETFs. The tide just appears to be going out, and I'm a stubborn contrarian, and a tough grader!

JEPI is a Sell to me. Specifically, I don't want to own it, I think it will disappoint investors versus what they expect over the next few years and it represents a category I once saw opportunity in, but which is now less attractive as markets change the assets flood into this ETF segment.

JEPI might continue to crank out consistent return, but I judge it to be good within its peer group, not iconic. It is not a "bad" fund, just an overrated one. And I'm concerned that's the level of overconfidence that is brewing among covered call ETF investors. After all, this strategy is not new. It is just relatively new in highly-structured ETF form.

Sungarden Investment Publishing