Introduction
2023 was a year that took many by surprise, including myself.
The S&P 500 Index (SP500) returned a total of 26.3% - carried higher by the outperformance of the Magnificent Seven. However, this 26.3% total return didn't come without a fair share of volatility - as the S&P 500 Index fell -10% over a three-month period during the latter half of 2023.
With that being said, there are many investors (including myself) who would prefer a more stable and predictable return - with income in mind.
In this post, I'm going to compare the total return of the three most popular S&P 500 Index covered call ETFs in an effort to better understand why the JPMorgan Equity Premium Income ETF (NYSEARCA:JEPI) performed so poorly in 2023 - as well as make a prediction for 2024.
2023 in Review
If you're an income investor like me, your portfolio is anchored by covered call ETFs that are benchmarked against the total return of the S&P 500. Unfortunately, 2023 proved not every S&P 500 covered call ETF is made equal.
Now, before you all come after me again with "You can't compare JEPI to the S&P 500 Index! JEPI doesn't hold the same stocks, it's a completely different strategy!"
You're right. However, the fund's investment objective as shared in their summary prospectus states the following (emphasis added):
"The investment objective of the Fund is to seek current income while maintaining prospects for capital appreciation.
The Fund seeks to achieve this objective by (1) creating an actively managed portfolio of equity securities comprised significantly of those included in the Fund's primary benchmark, the Standard & Poor's 500 Total Return Index (S&P 500 Index)..."
And as shown below on Morningstar, JEPI's benchmark index is the S&P 500.
Now that we're all on the same page, let's dive into the numbers, starting with JEPI.
JPMorgan Equity Premium Income ETF Facts:
The total return of JEPI in 2023 was 9.8%, capturing only 37% of the total return of the S&P 500 index.
As we all know, the S&P 500 Index was led higher in 2023 by the Magnificent Seven - seven stocks JEPI's fund managers understandably decided to leave out of the fund's holdings throughout the year. Only two of those seven names, Microsoft Corporation (MSFT) and Amazon.com, Inc. (AMZN), were held by the fund in 2023.
As stated in the summary prospectus, "The Fund seeks a lower volatility level than the S&P 500 Index." JEPI certainly achieved this, as the price of their shares only slipped -7.8% during the -10% drawdown the S&P 500 experienced between the months of August and October of 2023. And when you add monthly distributions to that figure, risk-averse investors become increasingly happier - a win in my book.
However, it's equally as important to ask yourself the question "Is the return I see the return I get?"
JEPI uses Equity Linked Notes (ELNs) to generate monthly income for their investors. In the eyes of the IRS, the income generated by these ELNs are taxed as ordinary income - meaning after taxes, this 9.8% figure might be materially lower for some folks depending on their tax brackets.
As a fellow JEPI investor, I'm constantly weighing my opportunity cost. By choosing JEPI over the next best thing, I'm capturing only 37% of the S&P 500's total return. Sure, I'm doing so in an effort to smooth out the volatility of my portfolio while also generating monthly income - but at the expense of upside potential and higher taxes.
Let's move on.
Global X S&P 500® Covered Call ETF (XYLD)
The total return of XYLD in 2023 was 11.0%, capturing only 42% of the total return of the S&P 500 Index.
XYLD was able to marginally outperform JEPI by 1.2% as the fund held "all the equity securities in the S&P 500 Index in substantially similar weight."
But, if XYLD held the Magnificent Seven inside of their fund, why did it only capture 42% of their S&P 500's total return? I thought the Mag Seven was the reason the S&P 500 performed so well?
They were.
But, unfortunately for my fellow XYLD investors because the fund wrote at-the-money (ATM) covered calls against their holdings, their total upside was capped at just the premium generated by the option contracts. According to XYLD's summary prospectus (emphasis added):
"The Fund writes a single "at-the-money" call option, which is when the strike price is near to the market price of the underlying asset, as determined on the monthly option writing date of the Underlying Index in accordance with the Underlying Index methodology.
The Fund's covered call options may partially protect the Fund from a decline in the price of the Reference Index through means of the premiums received by the Fund. However, when the equity market is rallying rapidly, the Underlying Index is expected to underperform the Reference Index."
And underperform it did.
However, unlike JEPI, XYLD uses Section 1256 contracts to generate their monthly income for investors. These Section 1256 contracts are treated much more favorably than ELNs in the eyes of the IRS - with income to be taxed as 60% long-term capital gains and 40% short-term, allowing investors to keep more of that 11.0% yield come tax time in April.
Neos S&P 500(R) High Income ETF (SPYI)
The total return on SPYI in 2023 was 18.1%, capturing nearly 69% of the S&P 500 Index's total return.
SPYI was able to materially outperform both XYLD and JEPI in 2023 by 7.1% and 8.3%, respectively. SPYI was able to do this by "investing in a portfolio of stocks that make up the S&P 500 Index," while also implementing a covered call option strategy that wrote covered call option contracts up to 5% out-of-the-money.
Let's take a look at SPYI's holdings (as of 1/22/24) to get a better understanding as to why this covered call ETF outperformed its competitors by such a wide margin:
As you can see above, the management team behind SPYI decided to write two covered call option contracts against the S&P 500 expiring on February 24 at the strike prices of 4,850 and 4,900. Assuming these contracts are rolled monthly, something SPYI's management team has stated in multiple interviews, they were likely written mid-January.
The S&P 500 Index was trading around ~4,750 during this time frame - which means their management team wrote these options contracts 2.1% and 3.2% out-of-the-money. These percentage points might not seem like a big deal, but when we have weeks like we did when these contracts were written (new all-time highs in the S&P 500 Index), writing out-of-the-money contracts vs. at-the-money contracts can move the needle from a total return perspective.
For added perspective, below are XYLD's covered call option contracts (as of 1/22/24) - choosing to write option contracts at the 4,800 strike price. At the time of writing, the S&P 500 is 4,839 - which would mean investors in XYLD aren't capturing any upside beyond 4,800 at the moment.
Similar to XYLD, SPYI uses Section 1256 contracts to generate their monthly income for investors - allowing them to keep more of that 12.16% annual distribution yield in their pockets when Uncle Sam comes knocking.
All in all, SPYI offered strong outperformance against XYLD and JEPI in 2023 - both from an income generation and tax-efficiency perspective.
JEPI paid out $4.62 per share last year, an 8.4% yield against their $54.98 closing price on December 29, 2023. XYLD paid out $4.15 per share last year, a 10.5% yield against their $39.44 closing price on December 29, 2023. SPYI paid out $5.80 per share last year, a 12.0% yield against their $48.20 closing price on December 29, 2023.
If you haven't yet read my mid-year JEPI vs. XYLD vs. SPYI total performance update, you may do so here.
What Does 2024 Have in Store for JEPI?
So JEPI didn't perform as well as its competitors in 2023 - but does that mean underperformance again in 2024? Let's take a look.
As of 1/21/24, the S&P 500's forward P/E ratio is ~19.5 - above its 5-year average of 18.9, and 10-year average of 17.6 (as shown below).
However, the above includes the Magnificent Seven - companies we know that had incredible returns in 2023. Some might also argue these names are trading at sky-high valuations right now, which according to FactSet, is ~33X price-to-earnings. When we subtract out the Magnificent Seven from the index, its P/E ratio drops to only ~15.5X.
Of course, we can't compare this "cherry-picked" 15.5X figure to the S&P 500's historical P/E ratio because that's just not how all of this works - but I would understand the argument that when omitting the Magnificent Seven from the index things begin to look a bit more "undervalued."
Furthermore, according to GuruFocus, the P/E ratio of the holdings inside of JEPI is ~17X - within spitting distance of the "S&P493's" 15.5X. Considering these figures are so close to each other, I'm not sure how much upside could be in store for JEPI's underlying holdings in 2024.
It would be incredible to see JEPI's P/E ratio inch closer to the S&P 500's 5-year average of 18.9, but with only Microsoft and Amazon from the Mag 7 helping lead the way - it could be difficult.
But that's not the only thing to consider for JEPI in 2024 - as many "price action analysts" are predicting a modest pullback this year after rate cuts go into effect during the second half of the year. If you're in this camp, perhaps JEPI will be able to provide your portfolio with stability amid the volatility. But again, at what expense?
According to Carson Investment Research (image below), during years following a year of 20% or more gains in the S&P 500, the index realizes a 12.1% median return - something I'm not convinced JEPI investors will be able to fully capture.
No one can predict the future, certainly not myself, but if the S&P 500 rallies 12% in 2024 led by the Magnificent Seven (something we've already begun to see happen year-to-date as we print new all-time-highs) - I'm fearful JEPI investors will experience back-to-back years of immense underperformance in relation to the S&P 500.
For an income-focused investor, total return doesn't exactly matter - what matters is how much income a portfolio is able to consistently and predictably produce. But, as I shared earlier, JEPI's 8.4% yield in 2023 was far below XYLD's 10.5% yield and SPYI's 12.0% yield - not to mention the ELNs being taxed as ordinary income, taking more from JEPI investors' pockets.
Conclusion
JEPI underperformed its competitors XYLD and SPYI by 1.2% and 8.3%, respectively, in 2023.
Given the method JEPI's portfolio managers generate income within the portfolio (Equity-Linked Notes), JEPI investors were hit with a double whammy - underperformance and higher tax rates.
Looking toward 2024, there's much to be desired. If history magically repeats itself, we could rally another 12% this year - led higher by the Magnificent Seven - names JEPI has minimal exposure to. This could mean leaving JEPI investors in the dust. If we experience a modest pullback after rate cuts begin to go into effect throughout the second half of the year, JEPI investors might be in a better spot than most.
As a fellow income-focused investor, I'm always weighing my options in efforts to determine the best possible way to invest my money. At the time of writing, I'm not sure JEPI is the answer here.
If markets rally because of the Magnificent Seven, both XYLD and SPYI's underlying portfolios would likely benefit from their exposure to those companies. With that being said, I do acknowledge that XYLD's option contracts are written at-the-money, while JEPI and SPYI seem to be written slightly out-of-the-money. If markets fall, both XYLD and SPYI offer a higher annualized distribution yield than JEPI, offsetting potential downward pressure on price. If markets rally, fall, trade sideways, or even in circles - both XYLD and SPYI will offer more tax-efficient income for their investors given their Section 1256 contracts.
To me, 2024 is a lose-lose-lose situation for JEPI investors.
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