JEPI ETF: high yield of 7.6%, good upside potential (NYSEARCA: JEPI)

Author’s Note: This article was released to members of the CEF/ETF Income Laboratory on March 3, 2022.

The JPMorgan Equity Premium Income ETF (JEPI) is an actively managed equity income ETF. The fund invests in both equities and equity-linked notes (ELNs), which are financial derivatives. JEPI shares offer the fund strong potential for double-digit capital gains. JEPI’s ELNs provide the fund with significant income and a strong dividend yield of 7.6%.

JEPI offers investors a solid income and potential capital gains, a rare and solid combination. The fund is a buy and is particularly suitable for income investors and retirees.

JEPI – Equity and Capital Gains Analysis

JEPI invests in both stocks and ELNs. These two asset classes have distinctly different characteristics, with JEPI being a fusion of the two. To understand JEPI as a whole, we first need to understand each of the fund’s asset classes separately, so let’s do just that.

JEPI focuses on large-cap US stocks, which represent between 80% and 90% of the fund’s value. Stocks are selected based on their fundamentals, volatility and risk-adjusted (expected) returns. Lower volatility relative to the S&P 500 is a key consideration and objective, which should reduce portfolio risk, volatility and losses during downturns and corrections. This has been the case during the ongoing correction, as the fund has outperformed most relevant broad equity indices since the start of the year, as expected.

Although JEPI did not exist in 1Q2020, at the start of the coronavirus pandemic, the JPMorgan Equity Premium Income Fund (JEPIX), the mutual fund version of JEPI, did. JEPIX and JEPI actually follow identical strategies, and so we can use JEPIX as a replacement for JEPI for the said quarter. JEPIX marginally outperformed most relevant broad equity indices during the quarter, as expected. JEPIX underperformed the Nasdaq-100, due to the latter’s significant exposure to the best-performing mega-cap tech sector.

Lower volatility of JEPI equity The portfolio should reduce losses in future downturns, corrections and recessions, a benefit for the fund and its shareholders. The ELNs of the fund are do not low volatility stocks, so the fund as a whole is only slightly less volatile than the S&P 500, at least under normal conditions.

On the other hand, low volatility stocks tend to experience less capital gains during bull markets and over the very long term. Security usually comes at a price, and that price is lower returns. JEPI itself has underperformed most general equity indices during bull markets and since its inception, as expected.

Finally, JEPI’s equity holdings are reasonably well diversified, with investments in 100 different companies and exposure to all relevant industry segments. The fund is currently moderately underweight technology, while being overweight industrials, consumer staples and utilities. Sector exposures appear roughly constant over time and reflect a bias towards cheap, undervalued and old economy industries. These sectors have performed particularly well in recent months, which partly explains the relatively solid performance of the fund since the beginning of the year.

JEPI – ELN and Dividend Analysis

JEPI’s other significant holdings are a set of leveraged ELNs. These represent between 10% and 20% of the fund’s value. The exposure is higher because these are leveraged investments. This means that these ELNs represent a small part of the fund’s value, but a significant part of the performance, income, characteristics, etc. of the fund. JEPI’s ELNs are derivatives that provide exposure to the returns of the S&P 500. more call options written on the same. These derivatives are functionally equivalent to a heavily leveraged position in the Global X S&P 500 Covered Call ETF (XYLD), previously covered here.

JEPI’s ELNs generate a significant amount of income, increasing the fund’s dividend yield to 7.6%. This is a high return in absolute terms, significantly outperforming all relevant general equity indices.

JEPI’s strong 7.6% dividend yield is the fund’s most important benefit and its fundamental investment thesis. JEPI is most an income fund, which investors buy for income. The other benefits of the fund, including its diversification, potential capital gains and reduced losses in downturns, also matter, but yield is key, at least in my opinion.

By the way, JEPI’s ELNs have little upside potential, but medium downside potential. Lower upside potential means lower capital gains and returns during bull markets and over the very long term, as discussed earlier. Although ELNs have medium downside potential, the fund’s equity holdings are relatively safe and low-volatility securities, and therefore the fund generally suffers less losses during downturns.

JEPI – Risks and other considerations

JEPI is a solid fund and an investment opportunity, but with several significant risks. The situation is a little complicated, not easy to summarize, but important.

JEPI’s equity investments are sometimes held for short periods. The turnover rate is quite high, reaching 195% in 2021. This is consistent with an average holding period of only six months and with a fund that changes its entire holdings twice a year. For comparison, the S&P 500 has a turnover rate of 2.0% and the average stock fund has a turnover rate of 31.0%, according to loyalty. JEPI’s high turnover rate is clear evidence of an actively managed fund. Thus, JEPI’s returns are highly dependent on the fund’s investment management team and its specific investment decisions.

As an example of the above, let’s take a look at JEPI’s largest holding, the DTE Energy Company (DTE). DTE is a regulated energy utility, with relatively safe, low-volatility revenue, earnings, dividends and returns, but lower potential growth and returns. The characteristics of DTE are typical of JEPI’s holdings. DTE is a recent addition to the fund, which was included in the second half of 2021. As DTE is the largest holding in the fund, it has a relatively large influence on the fund’s performance. DTE has outperformed the S&P 500 since being included in the fund, so it seems like its inclusion was the right choice.

DTE has performed particularly well since the start of the year, a period of moderate stock market declines. JEPI’s investment in DTE has resulted in higher returns and lower losses during the current correction, a strong combination.

JEPI’s performance depends on management correctly identifying and investing in top performing stocks such as DTE. While this is the case for most funds, it’s especially important for an aggressive, actively managed fund like JEPI. Remember that DTE is the largest holding in the fund, but it was only recently included in the fund and will likely be sold in the coming months (remember that high portfolio turnover rate). These constant movements create the opportunity for massive gains Where losses, with results ultimately depending on the specific investment decisions made by the fund management team. I reviewed several of the most important investment decisions recently made by the fund. All the decisions seemed reasonable, none seemed questionable or reckless, but things can always change, and sometimes for the worse.

Furthermore, leveraged ELNs, including those held by JEPI, are excessively risky securities.

Leveraged ELNs significantly underperform during downturns, as was the case for several mREIT-focused leveraged ELNs during 1Q2020. The losses have been massive and almost certainly will be in a future downturn.

As such, I would not invest in a fund focused on these securities. JEPI’s ELN position is relatively small at only 10%-20% of its value, which greatly reduces the overall risk of said securities and has prevented the fund from incurring excessive losses in 1Q2020, unlike some others. Leveraged ELN. In my opinion, JEPI’s ELN allocation is low enough that the risks are not excessive. More risk-averse investors, particularly those who want to limit their exposure to complex leveraged products, might disagree and should choose to invest in other funds.

The combination of aggressive active management and investments in leveraged ELNs could potentially result in significant losses during a downturn. JEPI’s ELNs significantly underperform during downturns. JEPI stocks generally don’t, but only because the fund’s managers have been successful in picking reasonably safe stocks during previous downturns. There is no guarantee that the fund’s managers will successfully pick appropriate stocks during future declines. Failure to do so could result in the fund experiencing above-average losses and underperformance. Although this has not happened in the past, it is a risk for the future.

These are strange and complicated questions, but terribly important. JEPI’s 7.6% dividend yield comes from highly leveraged ELNs. These are incredibly risky investments. Although these risks have not materially affected the fund’s performance in the past, this may not be the case in the future.

Conclusion

The strong dividend yield of 7.6% and potential capital gains from JEPI make the fund a buy.