Recently, I’ve covered both the QYLD ETF and the NUSI ETF, which use options strategies
to provide investors with high monthly dividends.
However, there’s one other ETF that I often see mentioned alongside these two, and that’s
the JP Morgan Equity Premium Income ETF, ticker JEPI, which I’ll be referring to as JEPI
in this video.
On the surface, JEPI looks like a safe choice for monthly dividend income, with an annualized
yield currently sitting at about 8%.
When I took a closer look, I realized that the majority of that 8% yield comes from about
15% of the JEPI portfolio, which happens to be a pretty mysterious and complicated group
of holdings.
And the more I looked around for info on this part of the portfolio, I realized nobody is
talking about it because one, people either don’t understand it or choose to ignore
it, and two, JP Morgan gives us very little information on it themselves.
So in this video, we’re breaking down the JEPI ETF and its strategy so that any potential
or current investors out there have a full understanding of where their money is going.
After doing a brief overview of the strategy and characteristics of the fund, we’ll dive
into JEPI’s stock holdings, which make up about 80% of the portfolio.
Then, we’ll get into the gritty details about ELNs, or equity-linked notes, which
are the instruments that JEPI uses to produce the majority of its dividend yield.
These make up just 15% of the portfolio, but they’re really the defining characteristic
of this fund and have some mysterious qualities that we need to take a look at.
After understanding the overall strategy, we’ll take a closer look at the dividend
and consider what to expect from it in the future, specifically in regards to the reliability
of the yield and its tax treatment.
Finally, based on all of this information, we’ll try to answer the question “should
you invest in JEPI?”, so let’s get started!
As the name suggests, JEPI is a fund designed to deliver high income to investors, without
sacrificing the potential for capital appreciation.
Specifically, the fund aims to provide a majority of the returns associated with the S&P 500,
while also providing lower risk, lower volatility and regular income.
JEPI accomplishes this with two main components: the first is low volatility, large cap stocks,
most of which pay dividends.
This strategy is fairly common, especially among standard dividend ETFs, and provides
the low volatility aspect of the portfolio.
However, this strategy doesn’t even come close to fulfilling that 8% dividend yield,
and that’s where the second component comes in, which is the use of equity-linked notes,
or ELNs.
The fund also has a small portion of their holdings in a money market fund and S&P 500
futures contracts, at about 2% each, but considering they’re so minor, I won’t be covering
them here.
Instead, we’ll break down both of their larger positions further, starting with the
simpler stock component.
The first thing to understand about JEPI’s stock portfolio is that it’s actively managed.
The team of advisers at JP Morgan will actively research and select stocks that they believe
will have less volatility than the S&P 500.
They will mostly be choosing stocks from within the S&P 500, although they do say that they
may also include stocks outside of the index.
They have a three-step stock selection process, starting with research, during which they’ll
determine an estimated fair value of the stocks involved.
Step two is ranking all stocks by valuation, so that they can find the stocks that are
considered to be most under-valued.
Using this information, they’ll buy and sell stocks from their portfolio as they deem
appropriate.
They also consider criteria like potential catalysts and the risks involved with each
stock.
Interestingly, even though this is an income focused fund, it says they do not select stocks
based on anticipated dividend distributions.
To me, this means they’ll probably look beyond high-yielding stocks simply because
they’ll pay a nice dividend, and instead focus on their research-driven criteria.
So overall, JEPI uses a pretty standard value investing approach to build its stock portfolio.
Because they’re choosing stocks from the S&P 500, most of these are going to be large
cap stocks, and they’ll likely gravitate to the blue chip dividend stocks that exhibit
low volatility and steady growth.
As of June 8th, 2021, they hold 91 different stocks that make up about 82% of the portfolio.
Most stocks are weighted between .5% and 1.5%, and you can see the top holdings are all pretty
small positions.
When comparing the sector breakdown to the S&P 500 via the SPY ETF, we can see that JEPI
has lower exposure to the more volatile technology sector and more heavily favors sectors like
utilities and industrials, which should provide lower volatility and steady dividends.
To quickly touch on active management, although I normally take the opposite stance, I don’t
see it to be a huge threat with this fund.
With over 90 holdings fairly evenly weighted, I think they’ve diversified away a good
amount of risk while maintaining decent exposure to the S&P 500.
My biggest fear with active management is picking the wrong stocks, but with a portfolio
like this, I don’t think we’d be able to tell one way or another.
Furthermore, the fund only has a .35% expense fee, which is pretty reasonable for active
management.
Additionally, the portfolio turnover sits at a reasonable 13%, so it doesn’t look
like the managers are trading too much and creating higher costs for investors.
But, like I said, JEPIs stock holdings only pay a small fraction of its dividend yield,
and on their own, would not provide investors with anywhere near an 8% annual dividend.
How can we tell?
If we look at their semi-annual report, which covers the last 6 months of 2020, we can see
that they paid out nearly $6 million dollars in dividend distributions to their investors.
However, during this period, they only earned $840,000 in dividend income from the fund’s
holdings - or about 1/7 of the money paid out in dividends.
This means if the fund was relying on their stock holdings alone to pay dividends, investors
would only get a 1 to 2% yield.
Fortunately, the ELN component of this ETF picks up some major slack to fund dividend
distributions.
Before we get into this, I want to reiterate that ELNs are a fairly complicated investment
instrument and they can be structured in a lot of different ways.
Plus, even though JEPI markets itself to be a transparent fund, there’s actually a rule
surrounding ELNs that they don’t have to be registered as individual securities.
So most of JEPI’s ELN activity is happening behind the scenes, and we’re left connecting
the dots to figure out exactly how they’re being used.
In any case, we’ll start by breaking down ELNs generally, and then we’ll get more
specific to understand how JEPI uses them.
So an ELN, which again is an Equity-Linked Note, is somewhat of a blend between fixed
income investments and traditional stock investments.
So first, let’s imagine a fixed income investment like a government bond.
These conservative investments involve lending your money at a fixed interest rate.
So let’s say you invest $100 in a government bond with a 3% interest rate that matures
in 5 years.
For the next 5 years, you’ll collect $3 in interest every year.
Once the bond reaches maturity, you’ll be paid back your initial $100 of principal.
With this investment, you’ve collected a fixed income with minimal risk, knowing that
you’ll receive your initial $100 back when the bond reaches maturity.
This is a preferable investment for low-risk investors because it’s predictable and practically
eliminates the risk of your investment losing money.
An ELN works much like a bond or other fixed income investments, with two key differences.
First, the money lent to invest in an ELN is going to be invested in stocks, hence the
equity-linked note.
This may be into a single stock, a basket of stocks or even an index like the S&P 500.
Some even go beyond simple equity exposure and also use options within the ELNs to provide
more upside potential.
And in most cases, ELN issuers will provide 100% principal protection, just like you would
expect from common fixed income investments.
In other words, ELNs usually guarantee that you will not lose any of the principal you
invested, eliminating any downside risk for the investor.
The second difference is that unlike fixed income investments, you will not earn any
regular or fixed interest payments.
This is because the interest you receive is now linked to the performance of the underlying
assets, again, hence the equity-linked note.
Whereas fixed income investments will tell you the expected interest rate beforehand,
like our 3% bond interest rate example, ELNs will define what is known as a participation
rate.
This describes the percentage of returns you’ll receive if the underlying assets appreciate.
Here’s a quick example of how this might work.
Let’s say you invest $100 into an ELN that is linked to the S&P500.
By the time the ELN reaches maturity, the S&P500 has appreciated 10%, so your $100 investment
is now worth $110.
While you’re guaranteed your initial $100 investment back, the participation rate will
determine how much of those extra $10 in capital gains you get.
If your ELN has a 50% participation rate, for example, you only get 50% of the returns
beyond your principal - in this case, you would get $5.
If your ELN had a 100% participation rate, you would get to keep the full $10 in gains.
So overall, ELNs are a useful tool that enable risk-averse investors to benefit from equity
gains without risking huge losses.
Hopefully that all makes sense, because now we’re going to put it into context with
how JEPI uses ELNs.
According to the prospectus documents, the ELNs used by the JEPI fund combine exposure
to the S&P 500 with written call options, otherwise known as covered calls.
Covered calls are a basic options strategy that produces cash flow when you own the underlying
investment, but it caps your potential returns from growth.
I’ve covered it pretty extensively in my videos on QYLD and NUSI, so check out either
of those videos if you need more information.
As explained in a press release via Nasdaq.com, these ELNs allow them to sell covered calls
on the S&P 500 every week and generate income, without risking the principal invested.
In comparison, funds like QYLD and NUSI sell covered calls every month, albeit both on
the Nasdaq 100 index.
I think this is the first indication as to how JEPI can earn such a large portion of
their investment income from ELNs, and we can get a better idea of things by looking
at their quarterly reports.
This report shows their ELN holdings as of March 31, 2021, which represented 16% of the
portfolio at the time.
I want to point out a few particular things here:
First, they’re all from different issuers.
I imagine this is to minimize the risk of one of them going bankrupt and defaulting
on the note, as the principal would no longer be guaranteed in that scenario.
Next, they all have about a 50% participation rate.
Since covered calls limit potential gains on the underlying index, we wouldn’t expect
to see too much price appreciation on the S&P500 holdings.
But, this participation rate shows that JEPI will get approximately 50% of the cash from
selling those covered calls, as that would be cash beyond the invested principal.
Next, we can see that the expiration dates all fall about one week apart.
It’s likely that they’re holding each of these ELNs to maturity, and simply cycling
through with new ELNs each time one matures.
This is how they are selling calls every week, and it’s cool to see that they’re using
a consistent amount of cash for each one.
However, this is just about all the info we get on the ELNs.
JEPI does have a brief page on their website with some vague details about the ELNs they
currently hold, but there’s nothing there you can use to dig deeper.
So we do know that the ELNs are short term in duration, linked to the S&P 500 and have
about a 50% participation rate, but the rest is unclear.
We’re left assuming whether there’s a 100% principal guarantee, and we know absolutely
nothing about the actual covered call strategy within the ELNs.
I can only assume that they’re selling at the money call options, because that would
produce the highest premiums.
But whatever is happening within these ELNs, it must be pretty effective, because if we
look at the semi-annual report, they earned just over $5 million in investment income
off of about $26 million in ELNs.
That’s approximately a 20% yield over 6 months, which would be 40% annually.
I’d be shocked if this all came from covered calls on the S&P 500, when QYLD does the same
thing on the more volatile NASDAQ 100 index and barely yields 12%.
Furthermore, if there is no downside risk and these ELNs are so effective, why not use
them more heavily and generate substantially more income for investors?
At this point I’m just thinking out loud, because I honestly don’t know the answer
to these questions.
I don’t want to pretend like I have all the answers here, because I’m still a little
puzzled by how these numbers are adding up.
I just wanted to present how I’m interpreting this information, and I welcome any conversation
about it in the comments.
In any case, we can still make an informed analysis about the JEPI dividends based on
what we know so far, especially knowing where their dividends come from.
If we take a look at their dividend history, we can see that the dividend amount varies
quite a bit.
This chart from seekingalpha makes it easy to visualize.
And this variability comes from both aspects of their portfolio.
First, their stock portfolio is not going to pay consistent dividends every month.
Most of the stocks in their portfolio are going to pay quarterly dividends, and likely
on different schedules.
So this is going to affect the regularity of dividends from month to month.
The consistency and ability to pay monthly dividends is bolstered with the ELN component
of the portfolio, but this will be slightly irregular, too.
The premiums from covered calls will be higher in times of volatility, meaning that the ELN
holdings will produce lower dividends in a less volatile environment.
As we can see by the VIX, or volatility index, volatility has been on a steady decline over
the last year.
Although JEPI will benefit from these spikes in volatility with their weekly covered call
strategy, the gradual reduction in volatility does explain some of the reduction in dividend
yield as of late.
Ultimately, changes in volatility will affect the consistency of cash coming from ELNs,
and therefore the dividends that investors receive.
I think this is both a pro and a con for the fund depending on the type of investor you
are.
For investors who want to use this fund for income, it may be disappointing to know that
you won’t receive a consistent dividend distribution every month.
Specifically, if you plan on using these distributions to pay for bills and expenses, you may need
to leave a little wiggle room when estimating your costs and dividend income each month.
But, if you are simply using this as a long-term dividend strategy, I think it’s actually
attractive that JEPI isn’t locking themselves into a specific distribution rate.
When funds try to achieve a consistent distribution, there’s always the risk that their portfolio
doesn’t produce high enough returns to deliver that distribution.
In these scenarios, funds will often issue a return of capital to fulfill that distribution,
which over time, can drain the fund’s NAV and actually hurt your investment.
This is something we’ve seen with QYLD over the last few years.
The use of return of capital in JEPI, if any, should be shown in the annual report.
However, I’ve been checking the website for weeks and the report has yet to be released.
Considering this is the first year of this fund’s existence, we don’t know whether
return of capital will present in JEPI’s dividend distributions over the long term,
and we have nothing to confirm that they haven’t used any yet.
If they don’t, I imagine they are simply passing through their monthly income to investors,
which will have some inconsistencies but should protect the fund’s value over the long-term.
As investors, we just need to understand that there will be some variability in the dividends
as a result.
Overall, with the large-cap stock holdings and regular use of covered call ELNs, I’d
say the dividend from JEPI is pretty safe.
As we said, there will be some variability in the value of those dividend payments, but
the strategy seems pretty reliable.
I have one more note on dividends, and that’s taxes, because the use of ELNs comes at a
pretty significant cost to investors.
Again, JEPI’s investment income comes from two sources, dividend stocks and these ELNs.
These dividend stocks are likely distributing qualified dividends, which means that any
of that dividend income that is passed along to you will be considered qualified dividend
income, and falls under the favorable long-term capital gains tax rate.
However, investment income from ELNs is not considered to be qualified dividends, or even
a dividend at all.
Because ELNs are debt instruments, the returns earned from them are technically considered
interest.
Unfortunately, interest is taxed as income, and when JEPI distributes its ELN earnings
to you, you’ll owe income tax on it based on your income tax bracket, unless you hold
your shares in a tax sheltered account.
Considering that the majority of JEPI’s investment income comes from these ELNs, most
of the dividends you receive are likely going to be taxed at this higher tax rate.
Again, we don’t have confirmation on this just yet because the annual report has yet
to be published, but this is the expectation.
If you’re considering investing in JEPI, I would suggest keeping an eye on the website
for the updated annual report, as I will be, to defermine what to expect from the taxation
of dividends moving forward.
So after considering all of this, should we invest in JEPI?
To answer this, I want to revisit the fund’s goals, which are to deliver a majority of
the returns of the S&P 500, provide regular monthly income and reduce volatility.
With its stock and ELN strategy, I think JEPI delivers on these goals.
So far, it has tracked the S&P 500 pretty well using SPY as a comparison.
As would be expected with this strategy, you miss out on some growth in exchange for a
smoother ride along the way.
But, it has clearly managed to deliver some of the growth of the S&P 500 while paying
out monthly dividends.
Furthermore, thanks to their stock selection and the use of ELNs, JEPI should be well-hedged
against the downside to protect investor’s capital amidst volatility.
In the end, this is probably one of my favorite dividend income funds I’ve looked at so
far.
Thanks to the stock portfolio, it doesn’t completely sacrifice growth like QYLD.
Thanks to the ELNs, it has some downside protection and added yield without the added cost of
multi-part options strategies, like those used in NUSI.
So if I was seeking a safe dividend income investment, this makes the cut for me.
Of course, if you’ve been following my channel, you’ll know I’m more focused on growth
and total returns at this stage in my career, so I won’t personally be starting a position
in JEPI for at least a few years.
I hope this video has helped you understand JEPI and its strategy, and if you have any
questions or thoughts, feel free to drop them in the comments.
By the way, if you’re interested in free stocks or cash, check the links in the description
for some awesome promotions at WeBull and M1 Finance that’ll help you kickstart your
investing.
Thanks for watching & I’ll see you in next week’s video!