Covered call ETFs have become very popular in recent times as investors attempt to capture the best of both worlds – equity upside and regular income. The formula is simple enough, and it can work quite nicely. However, there is a time and a place for such things, and it is my view that time has passed for now.
One of the behemoths in this space is the JPMorgan Nasdaq Equity Premium Income ETF (NASDAQ:JEPQ), a wildly popular version of a covered call fund that’s collected nearly $9 billion assets in less than two years. In this article, we’ll take a look at the fund, and why I think you’re better off just owning equities for the time being.
What is JEPQ?
In short, JEPQ is an ETF that is managed by J.P. Morgan Asset Management, that invests in publicly-traded equities. It does so through common stocks and options, the combination of which it uses to create a covered call portfolio on Nasdaq-100 stocks, and indeed, that is the benchmark the fund uses.
The idea is to create current income while maintaining at least some potential upside from capital appreciation. To do this, the fund is very actively managed through both the Nasdaq-100 securities it owns as well as the call options it sells against those equities. For those unfamiliar with the strategy, it’s very simple. The fund owns a stock and then sells call options against that position, generating income in the process. The tradeoff for that income generation is that the fund is limiting its upside as it is essentially selling the rights to that upside when it takes the premium for calls.
You can read about how these funds work here, but basically, you sell the rights to your upside in exchange for income, which also serves to reduce cost basis and volatility. This is a great strategy in certain markets, especially down and sideways markets, because there’s no upside to give up. In these markets, covered call ETFs are outstanding and generally would be expected to outperform benchmark equity indices.
However, it is my view that 2024 is going to see new highs in the equity markets, and likely by a significant margin over prior highs. If I’m right, a covered call ETF is almost certain to underperform. You can make your own judgment on that, but for me, the time to own this fund was 2022 and the first half of 2023, not right now.
Let’s take a look at the holdings to get an idea of what the fund actually owns.
Given this is a Nasdaq-focused fund, you see the usual suspects there from mega-cap tech. This is a non-diversified fund, so if it’s hundreds of stocks in a fund that you’re after, it’s best to move on from this one. However, despite the fact that JEPQ doesn’t own very many stocks and is tech-focused, its volatility is actually lower than that of the S&P 500.
This is one of the benefits of a covered call strategy; the income you generate from selling options also serves to limit volatility. For context, the Nasdaq ETF (QQQ) has 17.7% annualized volatility, which is more directly comparable to JEPQ. The fact that JEPQ is ~660bps better than QQQ shows the benefits of this strategy as it relates to volatility.
Of course, the other benefit that is likely more attractive to investors is the distributions, which we can see below.
The distributions are paid monthly, which is terrific and much more desirable than the standard quarterly schedule. They do change every month, however, as the amount of options income the fund can generate is somewhat out of its control. Options pricing changes through the day every day, meaning there are times when selling options is more favorable and vice versa.
We are in a time of very low options premiums given the volatility index (VIX) is just 13. That’s very low, bull market territory and in my view, this kind of environment is exactly the wrong time to be selling options. The reason is because the premium generated is very low compared to when the VIX is 16 or 18 or 20, so selling the upside to your equities can be thought of as being on sale, or cheaper than normal. We want to buy when things are on sale, not sell them.
Underperformance in action
I want to reiterate that this fund is a very strong choice if you’re in the market for a covered call fund. It’s well managed and the strategy works based upon the constraints the fund has. What I’m saying is that the environment we’re in is wrong for this kind of fund, irrespective of how well constructed it is.
Below we have the price chart of JEPQ – which does not include dividends, so total returns are better than the below – and I see a chart that needs a bit of rest before continuing higher.
The reason I say this is because the negative divergence that is forming between the November high and the current high is accompanied by a much lower peak in momentum, via the PPO. What this means is that momentum is not confirming price highs, which is generally a warning sign that the trend is about to slow or change. In this case, the trend is higher, so I’d be on the lookout for some selling to digest this most recent up move as it looks to me the bulls are getting tired.
Finally, below are returns through the end of 2023 for JEPQ against the index it tracks, and this is exactly what I mean by giving up the upside during a bull market.
I’m sure anyone that held JEPQ through 2023 was happy with their returns. However, simply holding the Nasdaq-100 would have yielded much better returns. It is my view that this bull market is far from done, and I believe when 2024 returns are tallied, JEPQ will come out on the wrong end once again.