JEPI Has The Perfect Strategy For Playing The Top (NYSEARCA:JEPI) (2024)

Introduction

The JPMorgan Equity Premium ETF (NYSEARCA:JEPI) was brought to market a few years ago and has made massive headway, now amassing a very respectable AUM of $32B and delivering solid returns that at times have rivaled the prolific S&P 500.

This influx of investments has given this fund, and its sister fund JEPQ, a great reputation among investors and particularly among those seeking current income.

JEPI produces a very high income, paid out in monthly dividends. It is volatile, since the source of the income is both dividends from the underlying stocks but also the options overlay (more on that later), which produces income as well.

Holdings

JEPI's underlying holdings are actively selected by the fund manager, with a black box around the selection process.

This is as much as we get about that process from JPMorgan:

[JEPI] constructs a diversified, low volatility equity portfolio through a proprietary research process designed to identify over- and undervalued stocks with attractive risk/return characteristics

What we can see is that the fund has 133 holdings, with its top ten looking like this.

Comparing the holdings of an S&P 500 ETF (I am using SPY for this since it is the most liquid S&P ETF) to JEPI shows us how much the fund differs in terms of sector weights.

The individual holdings differ quite a bit, with major overlap in names we could expect like Meta Platforms (META), Amazon.com (AMZN), Microsoft Corp. (MSFT), Eli Lilly & Co (LLY), and Exxon Mobil (XOM). There are also quite a few names that don't overlap at all. To some surprise, Apple Inc. (AAPL) is on the list, as well as some other heavy hitters in the S&P 500 like Tesla Motors (TSLA).

When we look at a five-factor regression done on both the S&P 500 and JEPI, we see the major points of divergence.

To clue folks in who didn't understand what's going on in Figure 4:

• SMB is the size factor, i.e. "small minus large"
• HML is the value factor, i.e. "high minus low book value"
• RMW is the quality factor, i.e. "robust minus weak profitability"
• CMA is the capital factor, i.e. "conservative minus aggressive investment"

The two factors that JEPI is significantly overweight on compared to the S&P 500 are RMW and CMA, signaling that the companies held in JEPI carry the quality and investment factor in larger amounts than those of the S&P 500.

These are the two factors that have performed the best in the last 100 years, with those factors like SMB and HML that JEPI is at or underweight on having performed worse in the past decade.

Options Overlay

We can't discuss JEPI without talking about options. JEPI uses equity-linked notes ("ETNs") for its short exposure to the S&P 500. In the holdings, they look like this.

Because of the nature of how these are reported, it's very difficult for me to gauge the efficacy of their options overlay, as it is also somewhat of a black box the managers work inside of.

There are a few advantages and disadvantages to this kind of options overlay that are important to note:

• These are custom-made for JEPI and carry more counterparty risk than FLEX options, which are backed by the OCC
• There is no risk of early assignment with ETNs
• Custom ETNs are highly illiquid and cannot be offloaded easily

I would prefer for JEPI's managers to use FLEX options, as they are more transparent for investors and still offer custom terms for the managers to negotiate with the OCC. While I understand JPM's decision to use in-house ETNs (or I assume they are in house because their CUSIPs start with JPH), the lack of transparency makes it very difficult to understand what JEPI's short position actually is.

As it stands, I am unable to model the options overlay. This is a risk investors should not overlook. It is important to understand the workings of derivative ETFs.

Strategy

The primary reason I am bullish on JEPI is how it is positioned in the current market. The S&P 500 is hovering around its absolute highs, with the levels above us being mostly uncharted territory.

JEPI is doing the two things I would want to be doing when the market is at a new high:

• Hold low volatility stocks from the index
• Short sell volatility on the index

In the event of another pullback or drawdown, the highest volatility names will drop the hardest. These companies are primarily concentrated in the sectors that JEPI is underweight, like tech and communications.

However, JEPI is still able to profit off of the volatility of these stocks since it sells options against the entire index. This eliminates the need to also hold these stocks, and in their place, JEPI can be overweight dividend-heavy, low volatility companies like in the consumer staples and industrials sector.

The image above compares the VIX, or the S&P 500's volatility, to JEPI's volatility. Note where the jade areas are visible are times when JEPI is less volatile than the market, where the amethyst areas are times where JEPI is more volatile than the market.

We see from this chart that the VIX tends to spike farther than JEPI's volatility, meaning that it is generally advantageous to be selling that volatility over JEPI's, since it generally stays at a lower level and would command less premium. The higher the volatility level, the higher the premium associated options will pay out.

Risks

A major risk to JEPI is its lack of international exposure, meaning it will underperform world indices during periods of US underperformance. The US and international indices go through cycles, with US underperformance looking more and more likely as international indices have lagged for the last ten years. They will have to catch up eventually, either through their own rise or the fall of US stocks.

There is also a risk of losing out on the upside due to the nature of the short positions. In the event of a rise in the index that JEPI doesn't see (perhaps driven by tech or other sectors JEPI is underweight), JEPI will lose out on that upside as they will have to pay out on the short side of the trade without making it up on the long side.

This makes the long and short side of the JEPI trade operate differently from each other, as their returns are driven by different factors. This asymmetric trade has proven to be profitable so far, but past performance doesn't mean it will hold up moving forward. See the very recent bucking of the S&P 500 over JEPI as an example of this.

This rise in the S&P 500 has largely been attributed to sectors JEPI is underweight.

Conclusion

The JPMorgan Equity Premium ETF is a fund that sells options on the S&P 500 while holding significantly lower volatility stocks. I am bullish on this fund for several reasons.

1. It is heavy on the quality and investment factors, overweighting them against the S&P 500.
2. It is overweight lower P/E sectors relative to the S&P 500.
3. It is able to capitalize on elevated volatility from the VIX compared to its own holdings.
4. The options it sells are custom-made and are useful in avoiding assignment and counterparty risk.

JEPI should be used as an aggressive equity fund in a portfolio, and I recommend investors allocate no more than 30% of their equity allocation to this fund. It still comes with risks to consider, such as geographic concentration and upside loss due to the different return factors in the long and short sides of the trade.

Thanks for reading.

John Bowman