How the JEPI ETF works: Is it a buy as it lags the broader market?

The JPMorgan Equity Premium Income (JEPI) has become one of the most popular Exchange Traded Funds (ETFs) this year, helped by its strong yield and low volatility. The fund has attracted billions in inflows, bringing the total assets under management (AUM) to over $29 billion.

JEPI’s strength has also triggered inflows in other actively managed ETFs. For example, the Neos S&P 500 High Income ETF (SPYI) has seen its assets jump to over $400 million while the JPMorgan Nasdaq Equity Premium Income ETF (JEPQ) and YieldMax TSLA Option Income Strategy ETF (TSLY) have hit $6.8 billion and $720 million.

These funds have become incredibly popular because of their advertised yields, which is much higher than what short-term bonds and REITs are offering. TSLY advertises a yield of 75.75% while JEPI has a yield of 9.26%.

JEPI has grown to become one of the biggest ETFs in the world. It is the biggest actively managed fund and the largest one in JP Morgan’s family of funds. The fund gives retail investors an opportunity to use a concept that has been used by Wall Street investors for many years.

According to its prospectus, JEPI employs two key strategies to generate regular income for investors. First, the managers have created a basket of S&P 500 companies that they strongly believe in. It now holds 103 companies, with the biggest ones being the likes of Amazon, Microsoft, Adobe, Progressive, and Trane Technologies.

In terms of sectors, most companies in the fund are in the technology industry followed by Financials, health care, and industrials. In the next part, JEPI sells call options using equity-linked notes (ELN) that have an exposure to the S&P 500 index.

To understand how JEPI works, it is important for you to know how covered calls works. In options, a call is a contract that gives a person the option to buy a stock at a specific price within a certain period.

In a covered call, a person buys an asset like a stock and then sells the call option for a premium. For example, if a stock is trading at $32 and a call option that expires in a month is going for $1.50. Its strike price is $34.

In this case, if the stock drops to $30, the buyer will not be inclined to buy the stock for $34 since they can buy it in the open market for $30. As such, while the stock has dropped, you have made $1.50, the premium. Your loss will be just 50 cents.

If the stock remains unchanged, then you will make $1.50, which is a good outcome. This is not a bad return since it is 4.6%. Further, if the stock rises, you benefit from both the call option premium and the stock movement. 

Using these covered calls explains why JEPI is able to generate strong income in the financial market. It makes money when stocks rise and because of the covered call premium. 

JEPI vs SPY ETF returns

As mentioned, the main reason why investors have piled into JEPI is that it has a higher yield than many other ETFs. However, as I wrote recently on the TSLY ETF, this advertised yield means little in the longer term.

The best way of looking at JEPI is to compare it with the SPDR S&P 500 ETF (SPY). In the past 12 months, the SPY’s total return has been 13.39% while JEPI has returned only 6.79%. The same is happening this year since JEPI has risen by 5.92% while SPY is up by 16.98%. SPY’s performance is mostly due to the Magnificent 7 stocks that have surged this year.

The challenge for JEPI is that its total returns will likely continue shrinking as the fund gets bigger. In a recent article, an analyst termed this as the decaying earnings power problem because of its mechanical approach to selling option.

Therefore, the bottom line is this. While JEPI is a good ETF, it makes sense to only invest a small portion of your resources in it. Analysts recommend investing in simple ETFs like SPY, iShares Core S&P 500 ETF, and the Vanguard S&P 500 ETF (VOO.

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