Market Volatility? JEPI Can Help

JEPI ETF: upgrade from Hold To Buy

I last covered JPMorgan Equity Premium Income ETF (NYSEARCA:JEPI) back in September 2023 (see the screenshot below). In that article, I rate the ETF as a hold due to the following considerations:

I don’t see the current environment as a good setup for covered-call strategies in general, primarily due to considerations of risk-free rates and the current volatility index. I expect its future income to be under pressure due to high-interest rates and quieter volatility.

In this article, I will argue for an upgrade of its rating from HOLD to BUY because I think the above considerations have both run their course. In the remainder of this article, I will elaborate on the new developments since then. But the gist of my thought process is three-fold. First, risk-free rates have reached a peak (or at least a stable level) in my view. And at the same time, I expect market volatility to return to a higher level in the near future, thus providing a boost to JEPI’s income generation. Finally, due to JEPI’s relative underperformance since my last writing, its valuation has become more attractive relative to the broader market. To wit, JEPI underperformed the overall equity market by more than 12% in terms of price and more than 7% in terms of total return, as seen from the chart above.

Return of market volatility

The next chart below (top panel) shows the volatility index (the VIX index) and the dividend yield from JEPI in the past 3 years (bottom panel). As seen, the ETF’s dividend yields enjoyed an overall rising trend in the period highlighted by the yellow box to a peak of around 12%. In my analysis, a large driver for such an increase is the relatively high volatility and JEPI’s income generation mechanism. According to the fund’s description:

JEPI generates income through a combination of selling options and investing in U.S. large-cap stocks, seeking to deliver a monthly income stream from associated option premiums and stock dividends.

The stock dividends are a minor part of the income (the overall equity market, from which JEPI makes its picks, yields about 1.4% only) and the option premium provides the dominant majority of the income. And this mechanism works beautifully for JEPI’s income during much of 2022 and the first half of 2023. As seen in the chart below, VIX stayed relatively high with an average of around 24.3x in this period and spent extended periods of time above 32x. To better contextualize things, the median level for the VIX index in the long term (i.e., 50% percentile) is around 16.5x. A VIX index of 24.3x is above the 81% percentile of the index’s historical track record, and a value of 32x is above 94% of its historical track record.

Then in the second half of 2023 (when I last wrote on JEPI), I began to see signs of quieter volatility ahead due to the easing of macroeconomic conditions. The VIX index indeed decreased, more dramatically than I thought. As seen, VIX has stayed largely below 16x (i.e., below the historical average most of the time since then). And JEPI’s yield decreased in tandem as seen.

Looking ahead, I see a few factors that could cause VIX to increase. The first factor is simply the index’s tendency to revert to the meaning. The volatility index itself is volatile (i.e., stochastic). And like all other things of a stochastic nature, it tends to be pulled towards the mean when it strays too far away.

Besides this mathematical argument, I am also sensing heightened macroeconomic uncertainties given our persisting inflation and the Fed’s future policies. The recent change in the market’s expectation for interest rate cuts by the Federal Reserve has spooked investors and caused a large rise in the VIX as seen in the chart below. To wit, the VIX index surged to around ~20 following March’s hotter-than-expected CPI data. Then finally, I also see more geopolitical tensions since my last writing. The tensions at that time were still dragging on with no end in sight (such as the Russia/Ukraine war). Then there are new conflicts emerging, such as those between Israel and Hamas. The upcoming presidential election in the U.S. adds another element of uncertainty.

JEPI’s holdings and valuation

The final consideration involves JEPI’s specific holdings and the valuation premium (or discount). As aforementioned, due to JEPI’s relative underperformance since my last writing, its valuation has become more attractive relative to SP500. At the time of my last writing, SP500 was trading around a P/E ratio of 24x. Due to the sizeable price advancement since then, SP500’s valuation has expanded to almost 28x. In terms of the less volatile Shiller CAPE, SP500 trades around 34x currently, the third most expensive level since 1880 as seen in the chart below.

JEPI, in contrast, trades at a valuation that is far less concerning in my view. The next chart shows JEPI’s P/E in comparison to that of SP500. Note that the information provided in this chart is based on market data as of March 31, 2024. As seen in the next chart below, JEPI trades at 21.2x P/E, slightly lower than that of SP500 at that time. Also note that SP500’s P/E is now much higher than March 31 (see this source that I just checked).

Of course, it is possible that JEPI’s valuation has expanded since Mar 31 too. However, I do not think the expansion would be as dramatic as that from SP500 given the screening method used by JEPI (quoted below from its fund description) and its specific holdings (see the next chart below).

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

Because the screening algorithm is proprietary, I can only stipulate what “attractive risk/return characteristics” means. And judging by the holdings shown below, I believe the algorithm focuses more on value. As seen, some of the top holdings in SP500 (like NVDA and AVGO, which are both expensively priced) are missing from JEPI. Instead, it holds a bunch of tickers with more moderate P/E in the top 10, such as Progressive, Meta, AbbVie, and Exxon Mobil. Secondly, JEPI obviously does not follow an allocation strategy based on market cap either and thus is far less top-heavy than SP500 as seen. A major risk with the current overall equity market in my view (whether it is SP500 or the Nasdaq 100) is that a handful of tech giants, which are all priced at elevated P/E multiples, dominate these indices. With more diversified and value-oriented holdings, JEPI could offer a lower correlation to the overall market (however you want to define it), thus reducing overall portfolio drawdown in the case of a downturn.

Other risks and final thoughts

In terms of downside risks, JEPI largely faces the same set of risks generic to other ETFs that use the option overlay. These risks include the sensitivity of income relative to VIX (which again is ultimately random), the capped upside potential, etc.

Two risks that are more particular to JEPI involve its turnover rates and its expense ratio. As an actively managed fund, JEPI charges a fee of 0.35% – quite reasonable by the standards of actively managed funds. However, it’s a lot higher than the fee from many passive index funds (which feature fees lower than 0.1%) and could represent a sizeable part of the fund’s potential return. For example, a fee of 0.35% is about 5% of its current dividend yield. Depending on your tax situation (you receive the dividends as pre-tax income), the percentage could be even higher in terms of after-tax return. Speaking of taxes, note that the fund has a turnover rate of around 190% (again because it is actively managed), which could also be a cause for tax headwinds. Such headwinds are at the fund’s level and thus invisible to us as investors. However, being invisible to us does not mean they do not exist, or we are immune to them.

All told, my verdict is that the benefits now outweigh the risks under the current conditions. I see a stronger case for JEPI compared to the overall market now than I did when I last wrote about it. Hence, Thus, the goal of this article is to upgrade my rating to BUY. To reiterate, I anticipate heightened VIX ahead and view JEPI as an effective hedge against market volatility. Its holdings are more diversified, value-oriented, and less top-heavy, which further helps its hedging efficacy.