JEPI Vs. SPY: The Relative Lead Unlikely To Continue In 2023

Businessman draws increase arrow graph corporate future growth year 2021 to 2022. Development to success and motivation.

Galeanu Mihai

Thesis

Over the past year or two, I wrote several articles to alert readers about risks associated with the JPMorgan Equity Premium Income ETF (NYSEARCA:JEPI). When I published my first article on it back in June 2021, the fund was trading at $61. The fund suffered about a 10% price correction since then but pays a mouthwatering dividend yield of 10%+ as of this writing. Furthermore, on a relative basis, as shown in the following chart, JEPI outperformed the overall equity market by a good margin. The SPDR S&P 500 Trust ETF (NYSEARCA:SPY) suffered a total loss of more than 15% YTD. As a result, JEPI led the overall market approximated by SPY by about 10%.

The above combination of 10%+ yield and outperformance (even only in relative terms) may draw the interest of many potential investors. Thus, the logical question is whether its outperformance (either relative or absolute) can continue.

In the remainder of this article, I will argue that the answer is very unlikely for several reasons. JEPI’s lead in the short history since its inception was mainly due to the rotation to value stocks and also the use of options during large market corrections. And if we expand the historical context a bit, we will see such a combination is towards its end. And moreover, under “normal” circumstances (i.e., other market conditions), its equivalent mutual fund the JPMorgan Equity Premium Income Fund Class AA (JEPAX) fund, provides more historical data and shows a different picture.

Chart, line chart, histogram Description automatically generated

Source: Seeking Alpha.

JEPI and SPY: Basic information

Both JEPI and SPY are indexed with the S&P 500 index as the benchmark. Both hold large-cap stocks. SPY’s median market cap is $170.9 billion and JEPI’s is $103.5 billion. Due to the indexing method and focus on large caps, a lot of their holdings also overlap (and we will detail this later).

Now, the differences. JEPI is actively managed, and SPY is passively indexed. As a result, JPEI’s expense ratio of 0.35% is about 4x higher than the 0.09% charged by SPY.

JEPI uses a proprietary strategy to seek a combination of capital appreciation potential, high income, and low volatility. The strategy to achieve such a lofty combination lies in A) the selection of both overvalued and undervalued stocks, and B) the use of option overlays on these stocks. As detailed in the fund description (slightly edited with the emphases added by me), the JPEI fund:

Seeks to generate high income through a combination of selling options and investing in U.S. large cap stocks.

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

Seeks to deliver a significant portion of the returns associated with the S&P 500 Index with less volatility, in addition to monthly income.

Table Description automatically generated

Source: ETF.com

JEPI vs. SPY: Closer examination of holdings

As just mentioned, both JEPI and SPY are focused on the large-cap space. Since they draw from the same pool of stocks, they overlap quite a bit even among their top 10 holdings as seen from the chart below. You see UnitedHealth Group Inc (UNH), Microsoft Corp (MSFT), and Alphabet Inc (GOOGL) (GOOG) in both funds.

Although there are large differences in their holdings too. First, SPY holds the entire large-cap space (with ~500 stocks), but JEPI holds a subset of the large-cap space (with ~100 stocks selected by its proprietary research aforementioned). Hence, JEPI features a more concentrated portfolio. Second, JPEI’s selection strategy is more geared toward value, while SPY is indexed by market cap. As detailed in JEPI’s fund description (slightly edited with emphases added by me),

The fund advisers employ a 3-step process that combines research, valuation and stock selection. The research allows the adviser to rank companies according to what it believes to be their relative value… The Fund buys and sells … using the research and valuation rankings as a basis. In general, the adviser selects securities that are identified as attractive and considers selling them when they appear less attractive.

Hence, in a nutshell, JEPI is more value-oriented while SPY is indexed by market cap. And the fundamental differences in their indexing strategies can be easily seen from their top 10 holdings below. As seen, JEPI holds more stocks in the traditional value sectors such as health care (e.g., UNH, BMY, and ABBV) and consumer staples (such as Hershey (HSY) and KO). Moreover, JEPI holds these stocks at a higher concentration than SPY. In the meantime, it holds more growth- and tech-oriented stocks such as MSFT and GOOGL at a lower concentration than SPY. For extremely expensive stocks like Tesla (TSLA) and Nvidia (NVDA), JEPI avoids them completely.

Graphical user interface, application Description automatically generated

Source: ETF.com

Hence, as mentioned above, the lead of JEPI over SPY in the 1 or 2 years was largely due to the substantial correction of the tech and growth sector, which hurt SPY more than JEPI. And if the lead is to continue in the future, then we will need to assume that the value sectors will keep outperforming growth and technology stocks. However, this assumption does not seem to be a valid one at this time given the current conditions.

As you can see from the following chart, the S&P 500 index was priced at a large valuation premium compared to other sectors during 2021 and 2022 with a PE close to 24x. Such a PE is nearly 1.6x higher than healthcare (about 15x PE at that time) and about 10% above consumer staples (about 22x at that time). Then the correction came and hurt the S&P 500 more than these value sectors. To wit, SPY’s current PE is only 17.4x, essentially on par with healthcare’s 16.9x. And it is significantly below consumer staples, which stands at 20.7x PE, a record level since ~2000.

Chart Description automatically generated

Source: Yardeni.com

JEPI vs. SPY: How about the use of options?

The use of options (in the form of ELNs, Equity Linked Notes) can help generate high income, and the income increases as market panic heightens – like what we just experienced. In JEPI’s case, it employs up to 20% of its total assets on options. However, the option overlay will limit the fund’s upside potential as detailed in its fund description (again, edited with emphases added by me),

In order to generate income, the Fund may invest up to 20% of its net assets in ELNs… ELNs in which the Fund invests are derivative instruments that are specially designed to combine the economic characteristics of the S&P 500 Index and written call options in a single note form. The ELNs provide recurring cash flow to the Fund based on the premiums from the call… Investing in ELNs may reduce the Fund’s volatility because the income from the ELNs would reduce potential losses incurred by the Fund’s equity portfolio. However, the ELN would also reduce the Fund’s ability to fully profit from potential increases in the value of its equity portfolio.

Due to JEPI’s short history (it was launched only in 2021), I will use the next chart below to show the roles of the option overlay. The chart below uses JEPAX as a proxy to approximate JEPI. The JEPAX is a mutual fund that was launched in Sep 2018 with a strategy similar to JEPI. Hence, JEPAX provides ~3 years of data to see the role of the option under a broader range of market conditions.

Now you can see that over a longer timeframe, JEPAX lagged SPY by a large margin. Over this period of time, SPY offered a handsome return of 13.8% per annum and a total return of 64%. In contrast, JEPAX only returned 9.9% per year and 43% in total. It lagged SPY by ~5% on a CAGR basis and 21% on a cumulative total basis. And a key fundamental cause is the use of options that put a ceiling on the upside potential of a good part of its assets.

Chart, line chart Description automatically generated

Source: PortfolioVisulizer.com

Risks and final thoughts

To recap, in its short history, JEPI provided investors with an attractive combination of high dividend yield and relative outperformance. To wit, it led SPY by about 5% in total return YTD and it currently provides a 10%+ yield. For potential investors drawn to the fund, the logical question is whether its outperformance (either relative or absolute) can continue.

Unfortunately, my answer to the question is very likely. JEPI’s lead so far was mainly due to the rotation from growth and tech stocks to value stocks. The rotation is at an end because SPY’s current PE of 17.4x is on par with value-sector such as health care and far below consumer staples (20.7x). Furthermore, JEPI’s option overlay limits the upside potential in the long run as demonstrated in the case of JEPAX.

To close, I would suggest JEPI only to investors who need current income in a simple fund. For those who do not mind some DIY (not that much as detailed in my blog article ), I see a more dynamic approach combining a core fund (such as SPY) and a few tactical holdings as a more promising strategy going forward. Plus, you get to save the 0.35% fee charged by JEPI.

Be the first to comment

Leave a Reply

Your email address will not be published.


*