A Foolish Option
WHEN WAS THE LAST time you got scammed? Mine was about a year ago, when I threw more than chump change into a red-hot newfangled exchange-traded fund called the JPMorgan Equity Premium Income ETF (symbol: JEPI).
Now, JEPI could be the name of someone’s pet poodle, but it’s actually one of the more misunderstood high-income products in the burgeoning world of actively managed exchange-traded funds (ETFs). Just how red hot is the fund? Around for only four years, the fund has amassed more than $34 billion in assets and become the country’s most popular actively managed ETF.
It’s benefiting from a revival of enthusiasm for the option-income fund, a strategy with an underwhelming investment history but a surge of industry propaganda. On the surface, the JPMorgan Equity Premium Income ETF looks sweet. It offers a yield that has at times exceeded 12%, with a downside of less than two-thirds that of the broad stock market. Meanwhile, it still has some room for capital appreciation.
The fund’s advisors look for stocks of high-quality, fundamentally sound companies, most of which are members of the S&P 500. The portfolio is diversified across about 130 stocks, and is tilted away from the tumultuous and likely overvalued technology sector.
See how I got hooked? I even got victimized by the 0.35% expense ratio, which I saw as a bargain for an actively managed fund.
Just what is this contraption called an option-income fund? Its portfolio consists mostly of dividend-paying stocks. The fund’s managers sell instruments that, like options, are designed to slightly limit losses during a market decline. While you get some insurance, I’ve discovered that I pay dearly for it, in the form of a cap on the fund’s gains during up years. That restriction on how high your gains can go isn’t the only snafu here, but it’s the most important reason I should have stayed away.
The fund’s advocates like to point to its stunning performance when the market took a drubbing in 2022. The ETF lost only 3.5%, compared to the 18% decline in the S&P 500. What boosters gloss over is the fund’s subsequent lackluster showing. In 2023, it earned 9.9%, including dividends, while the broad market charged ahead by 26%.
Things are no better in 2024. Its return is 8.2% through July, compared to the S&P 500’s return of 15.8%. Let’s put it in plain dollars and cents: Since its inception in May 2020, a $10,000 investment in the vaunted ETF grew to about $16,300 as of this June, quite a bit short of the $19,600 returned by Morningstar’s comparable broad market index.
Yes, the protection it offers in a falling market could come in handy. But let’s get the truth out folks—stocks are in a bullish mode roughly two-thirds of the time.
The fund’s fat dividend is no bargain, either. First, the fund’s dividend yield has dropped from 12% to 6.4% as of July 31. Second, dividend is a misnomer anyway. This ETF’s distribution is actually a combination of dividends from its stock investments, plus income thrown off by the option-like vehicles known as equity-linked notes.
The dividend component of this combined distribution is actually quite small. How could it be otherwise when four of the fund’s top 10 holdings are technology behemoths that pay small dividends or none at all?
The lion’s share of the payout comes from those equity-linked notes, which—unlike dividends—are very much affected by the jumpiness of the market. People who trade options crave action. They’re driven to them when stocks are the frothiest.
That’s why the fund’s distribution topped 12% when market volatility was high. The yield has gradually subsided to 6% as the market has become less lively.
The ETF’s monthly payouts to shareholders are a nice feature, but hardly anyone I know likes a variable distribution. Retirees using dividends to pay for essential living expenses prefer their income stream to be steady.
The fund’s deficiencies go beyond its lagging returns and uneven payouts. Income from the fund’s dividends and option-like notes are treated as ordinary income. The fund’s dividends are not considered qualified. After taxes, that 6.4% dividend becomes worth something like 4.6% for me. That’s close to the rate I can obtain practically risk-free from a money market fund.
Don’t make the same mistake I did. You’ve got two good options for this option-income fund. Own it in a nontaxable account or—better yet—pass it by.
Steve Abramowitz is a psychologist in Sacramento, California. Earlier in his career, Steve was a university professor, including serving as research director for the psychiatry department at the University of California, Davis. He also ran his own investment advisory firm. Check out Steve's earlier articles.
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