JEPI: How To Evaluate If It’s Worth It

Recently, several investors have piled into JEPI (JP Morgan Equity Premium Income ETF) because of its attractive 12% income distribution yield and opportunity to capture similar capital appreciation as the S&P 500, but with lower volatility.  This actively managed ETF has been particularly tempting for income investors used to investing in dividend ETFs. While JEPI has been written about extensively earlier this year, few articles discuss the opportunity cost and risks of investing in JEPI.  In this blog, we will evaluate whether it makes sense to consider JEPI in our portfolio as an income performance enhancer.  We will explore different tax and price depreciation scenarios to inform our analysis.

Disclaimer: Please note that the information and analyses that we share below are our opinions and not investing advice.  Every individual’s investment objective and risk profile is different.  Therefore, please remember that every investment has risks. Before investing, conduct your own due diligence and consult your financial advisor.

Overview of JEPI

According to JP Morgan’s fund profile, JEPI is an actively managed ETF that seeks to provide high monthly income while maintaining prospects for capital appreciation.  Portfolio managers, Hamilton Reiner and Raffaele Zingone co-manage the fund with a team of analysts. While both portfolio managers have over 60+ years of investing experience, the fund is relatively new with the inception date of May 2020. Therefore, there is a lack of historical performance data associated with this fund, which may increase the investment risk.

The Fund’s investment approach centers on creating an actively managed portfolio of S&P 500 blue-chip companies that pay dividends and through equity-linked notes (ELNs), sell call options with exposure to the S&P 500 index.  ELNs are a type of structured product that offer investors exposure to the performance of an underlying equity or equity index. For JEPI, this would be the S&P 500.  ELNs act like bonds that are held to maturity but their returns are linked to the performance of the price movements of the underlying equity or equity index.  Therefore, if the price of the underlying asset does well, the ELN may provide a higher return.  JEPI appears to sell new call options inside the ELNs every week, simply cycling through ELNs once they expire. The ELNs are the secret sauce behind this ETF’s return strategy.

JPM summarizes their overall total return strategy for JEPI below in their fact sheet:  

For the income component that is derived from options premiums, the Fund may invest up to 20% of its net assets in ELNs which suggests that the 5-8% distribution (or ~80% of the total income return) could vary depending on the market volatility.  In the chart below, the monthly payouts can either be 15% to 23% higher or lower than the prior month.  Additionally, during 2022’s highly volatile market, the average distributions were 47% higher than 2021.

The average monthly adjusted closing price for the VIX was 26% higher in 2022 vs. 2021, translating into a 47% higher distribution payout for JEPI.  Volatility matters!  However, the opposite can also be true when the VIX is less volatile.  So far in 2023, the average monthly VIX is around 18 with the average payout dropping from $0.53 / month to $0.43 / month.  While no one can predict the future, there are few key macroeconomic events that could significantly influence the direction of the VIX:

• US debt limit
• Subsequent failures of regional banks
• Commercial real estate debt crisis
• Federal Reserve actions towards interest rates (continued hiking or rate reductions)
• Additional geopolitical forces (e.g., Ukraine War, US-China Relations)

Any combination of these potential events could lead to greater volatility in the short-term.  From a forward-looking perspective, management has shared that it expects 1-2% capital appreciation and 5% to 8% long-term yield or 6% to 8% annual returns.

Other important differences for JEPI vs. traditional dividend ETFs include:

1. JEPI’s income from options premiums will vary based on the fluctuation of the underlying stock price and market volatility
2. ~80% of JEPI’s income from the options premium will be taxed as ordinary income

Finally, the annual expense ratio and management fees for the fund is 0.35% of the value of your investment. This is not terrible considering the average expense ratio for actively managed ETFs is 0.70%.

JEPI’s Advantages

For income investors looking at a shorter time-horizon (e.g., 1-2 years) or retirees with limited ordinary income, there may be several advantages when investing in JEPI:

• High income distribution from ELNs given greater than 50% participation rates based on recent annual and semi-annual reports of ELN positions
• Down-side protection and lower volatility than the S&P 500 especially during down markets; in 2022, JEPI was only down 3.53% whereas SPY was down 18.17%
• Diversified positions across 115 high quality large cap equities with no position greater than 1.62% and nearly even sector diversification across financials (12.8%), healthcare (12.0%), consumer staples (11.7%), industrials (11.4%) and IT (11.3%)
• Short-duration ELNs, diverse number of issuers, recently reduced size of individual positions (no ELNs in the top 10 positions) and a fund cap of 20% mitigates counterparty risk of issuers going bankrupt and defaulting on the note, minimizing loss of investor principal
• Relatively low expense ratio for an actively managed fund compared to others  

JEPI’s Disadvantages

Like all investments, the key risks for JEPI include under-performing long-term appreciation relative to SPY, unpredictable dividends, counterparty risk in ELNs and income taxed at ordinary income rates. 

• Limited opportunity to capture full upside potential during a bull market rally vs. SPY
• Limited transparency on details of ELNs because they do not have to be registered as individual securities under the Rule 144A or section 4(a)(2) of the Securities Act of 1933, making it difficult to estimate the extent of downside protection in the event of issuers defaulting on the note
• Potential for income from ELNs to collapse in the event of counterparty risk during a financial crisis, and if that occurs, this may lead to a reduction in ETF share price
• Irregular monthly dividend payments and lack of consistent dividend growth
• High turnover ratio recently means that the expense ratio could rise in the future
• 80-85% of JEPI’s income are taxed as ordinary income because they are derived from ELN and covered call similar to REIT dividends instead of qualified dividends (e.g., VYM or SCHD)

Income and Tax Analysis for JEPI

Since most of JEPI’s income will be taxed at ordinary income rates, we analyzed the potential pre- and post-tax income based on different tax scenarios for investors in the Top 1% and Top 10% tax brackets for an initial $100,000 investment.  For reference, we also explored the net income and yield if we were to invest in JEPI in a tax-deferred retirement account (Traditional or Roth IRA) where taxes would not apply.

Annual Net Income After Taxes:

For this analysis, we assumed 80% of the income distribution would be classified as ordinary income from federal and NYS taxes and the remaining 20% would be subject to qualified dividends capital gains treatment.  We based this assumption on how the fund generates income via qualified dividends from the defensive equities and the options premiums it receives by selling call options.  The annual distribution per share was cited based on the TTM payouts between 6/1/2022 to 5/1/2023.  We also deducted the expense ratio in the post-tax distribution yield for both tax brackets.  Please see the annual pre- and post-tax distribution yield below:

As expected, if you are in a lower tax bracket, your post-tax distribution yield is higher at 7.9% given tax rates scale at higher income levels.  Both annual post-tax distribution yields are also 2.3X the after tax risk-free rate, making the risk-reward appealing.  The post-tax distribution yield would look even better if you live in a state that does not have state income tax like NY!

Additionally, we need to remember that if there’s less volatility, we could potentially see these yields compress by 47%, suggesting that the after-tax distribution yields could be ~3.4% to 4.2% respectively for top 1% and top 10% earners.

If you are investing in JEPI in your IRA, the taxes on the income distribution are either deferred until withdrawals (e.g., traditional IRA) or exempt from taxes if you have it inside a Roth IRA.  Therefore, your annual yield would be 11% based on the trailing twelve months.

Opportunity Cost of JEPI

Investing cash at JEPI without considering the potential “loss” of capital would be unrealistic, especially during highly volatile markets near-term.  We need to consider our potential downside risk and relative risk-adjusted yield for different price depreciation scenarios compared to the risk-free investments (e.g., CDs or money market funds). For this analysis, we assumed JEPI’s TTM distribution yield and payouts and the risk-free rate to be 4.89%.

We tested different price depreciations for Top 1% and Top 10% tax bracket investors relative to the risk-free rate of return.  For each scenario, we calculated the annual net yields based on the % price loss to our starting principal investment offset by the post-tax distribution income.

For Top 1% tax bracket investors, if JEPI experiences a 3.5% loss in stock price, the post-tax yield in a taxable account (assuming you lived in NYS) would result in essentially the same net yield as the risk-free rate. For Top 10% tax bracket investors, if JEPI experiences a 5% loss in stock price, the post-tax yield would start to be less than the after-tax risk-free yield. If we were to run the same analysis without factoring in taxes, assuming JEPI is in a tax-deferred account, JEPI would need to drop by 7% for the net yield to start to be lower than the risk-free yield.  What we can infer is that the opportunity cost for JEPI makes sense when market prices remain relatively stagnant or modulate modestly.

When prices drop below 7% for investors with JEPI in taxable accounts, they would begin to lose money on their principal investment assuming distributions remain constant.  For investors with JEPI in tax-deferred accounts, they would start to lose money on their principal once prices drop below 10%.

Therefore, if JEPI’s share price were to drop 7% y/y (essentially double the loss from 2022), I would still be kept whole for taking the risk as my principal would be net neutral.  However, if the price were to stay relatively flat, I would be earning 2.3X more than the risk-free return.

Conclusion

In summary, as an investor in the Top 1% tax bracket, I plan on considering JEPI in my tax-deferred IRA account because of the following reasons:

• Net income yields are higher than risk-free investments during times of highly volatile sideways or bear markets given demand for value-oriented equities
• Content with sacrificing potential “upside” if a bull market occurs or when there’s a rotation to risk assets as other parts of my portfolio are already invested in the S&P 500 and growth stocks
• Management’s longer-term projections of 6-9% income returns remain attractive relative to traditional dividend ETFs and risk-free returns will decline once the Fed lowers interest rates
• Even though historical performance does not guarantee future results, price depreciation scenarios of greater than 7% may be less likely given in 2022, JEPI was only down on average ~3.2% y/y when the Fed rapidly raised interest rates
• Counterparty risk can likely be managed even if the banking crisis continues because 1) ELNs are currently below the fund cap, 2) no dominant ELN positions within top 10, 3) short duration maturity ELNs and 4) diverse set of counterparty banks vs. concentrated counterparties and 5) SEC Rule 12d3-1 of the Investment Act of 1940 caps single issuer risk to 5% of ETF portfolios

If I were in lower tax brackets or have low amounts of ordinary income, then this would be even more attractive to me!

In looking ahead, two near-term market scenarios may be likely:

Scenario 1: If we assume the market will continue to trade sideways, volatility continues, and interest rates remain higher for longer through the end of 2023, then the total return for JEPI will likely continue to be attractive.  We believe this thesis because the demand for value stocks will be high and investors will desire higher income in order to “get paid” to wait.

Scenario 2: If the Fed starts cutting rates, then we could see a rotation into risk assets and away from value.  At that point, JEPI’s stock price may decline and income from the options premium may also be reduced from current levels given lower volatility and more demand for tech/growth stocks vs. value stocks.  This scenario may be more likely starting in 2024 when the Fed expects to reduce interest rates, but the market’s sentiment could start earlier toward the end of 2023.  This scenario is supported by management’s forward-looking longer-term projection of income yields to return down to 6-9% over time.  Investors may still find 6-9% pre-tax yields attractive, especially with lower volatility given the current climate with emerging uncertainty within real estate, regional financial banks as well as other geopolitical risks internationally, making it difficult to find other investments that produce reliable yields.

Our approach is going to be to allocate a portion of our portfolio to JEPI in addition to existing VOO portfolio holdings.  We hope our analyses above have been helpful when evaluating JEPI in your portfolio.  As a reminder, please do your own research, read the fund’s published literature and understand the risks before investing!

If you are interested in the free investment tools that we use to inform our research and analysis, please check out the following:

• Portfolio back-testing: Portfolio Visualizer
• Stock screener research: FinViz.com
• Company fundamentals analysis: Stratosphere.io

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