Dividend investors are facing an increasingly difficult time finding investments that provide consistent and solid income in today’s market, where prices remain high and major indexes are near record highs. One type of investment that has gained popularity over the past five years is covered call funds, which focus on dividend income.
One popular exchange-traded fund (ETF) that employs this options strategy is the JPMorgan Nasdaq Equity Premium ETF (NASDAQ: JEPQ). Since its inception in early May 2022, JEPQ has provided investors with a total return of 23.53%, outperforming the S&P 500 (SPY), which has delivered a total return of 23.25% during the same period.
In September 2023, I recommended JEPQ as a ‘buy’ primarily due to my belief that increased volatility and currency fluctuations would benefit the ETF’s income and overall returns. Now, I am upgrading my rating to a ‘strong buy.’ Volatility levels in the market are likely to continue rising throughout the year due to factors such as the upcoming presidential election, a slowing but stable economy, and heightened geopolitical tensions abroad. Additionally, earnings estimates for large-cap technology companies remain solid, which should mitigate some of the downside risks associated with this fund. JEPQ’s strategy of selling out-of-the-money options should also be well-suited for the expected market conditions in 2024.
Let’s take a closer look at JEPQ’s key features:
– Expense ratio: 0.35%
– Assets under management: $11.67 billion
– Trailing yield: 9.49%
JEPQ aims to track the Nasdaq 100 index, with its holdings primarily consisting of technology (49.76%), communication (16.11%), consumer cyclical (13.51%), healthcare (6.62%), consumer defensive (6.21%), industrials (4.01%), basic materials (1.29%), utilities (1.08%), financials (0.67%), energy (0.47%), and real estate (0.29%). Additionally, the ETF has holdings in corporate bonds (16.95%) and cash and equivalents (0.57%).
JEPQ reserves the right to invest up to 20% of its monthly income, primarily derived from selling options, in bonds.
Similar to the JPMorgan Equity Premium ETF (JEPI), JEPQ employs an options strategy that involves selling monthly out-of-the-money calls that are approximately 5% out of the money. This allows investors to participate in some of the upside potential of the underlying assets while also receiving income from the monthly options premiums and regular dividends. It’s important to note that the income generated from these options is taxed at ordinary income rates.
JEPQ’s monthly payouts have ranged from $0.33 to $0.68 since its inception, with consistent monthly payouts of $0.38 to $0.43 per share since early 2023.
Options funds like JEPQ tend to perform well in periods of elevated volatility, but it’s crucial to recognize that there is some risk to the principal involved. The volatility premiums associated with the monthly options sold by JEPQ are higher when the market is more volatile. However, since the fund caps upside potential while leaving downside risks unlimited, investments like JEPQ may underperform during severe market sell-offs.
International tensions remain high, with recent missile exchanges between Israel and Iran, the ongoing conflict between Israel and Hamas, and the unresolved conflict between Russia and Ukraine. The VIX, a measure of overall market volatility, is also currently at a five-year low.
Most economists anticipate slow growth rates both in the U.S. and internationally this year, and the upcoming 2024 presidential election in the U.S. is likely to introduce further uncertainty regarding the future of monetary and fiscal policy.
While economists predict that the U.S. and most G-8 countries will avoid a recession in 2024, growth is expected to remain sluggish for some time due to the lingering impact of rising interest rates. Volatility levels are likely to increase throughout the year despite strong earnings estimates and relatively stable growth rates. The Federal Reserve’s stance on the current rate cycle remains unclear, and the economy is far from robust. The IMF recently projected a baseline global growth rate of 3.2% for 2024, characterizing the global economy as slow but resilient.
JEPQ and JEPI both employ options strategies that involve selling monthly out-of-the-money calls. Over the past several years, both funds have outperformed many other covered-call funds that sell at-the-money options, such as RYLD and QYLD.
ETFs that sell at-the-money calls have generally experienced greater net asset value (NAV) losses compared to funds like JEPQ and JEPI, which provide investors with some upside potential in the core holdings of the ETFs. The NAV losses incurred by funds selling at-the-money calls, even in the relatively strong market performance of the past two years, should raise concerns among investors.
Like all investments, there are risks associated with JEPQ. If the economy were to experience a significant slowdown and the fund were to sell off sharply, JEPQ would likely underperform most indexes due to its options strategy, which limits its upside potential. The Federal Reserve’s decision to maintain higher interest rates for an extended period may also lead to a continued rise in the value of the U.S. dollar against major foreign currencies. Big-cap technology companies derive approximately 60% of their earnings from outside the U.S. Additionally, if the economy were to strengthen and inflation were to decline, volatility levels would likely decrease, and the income generated from selling monthly calls would likely fall to the lower end of the recent range JEPQ has experienced, around $0.33 per month.
Despite these risks, the most likely market scenario for 2024 is a relatively range-bound market with elevated volatility due to multiple uncertainties in the U.S. and international economies. The Federal Reserve’s recent decision not to lower interest rates introduces further uncertainty regarding the current rate cycle in the U.S.
Although covered call funds are not designed to outperform the broader indexes over extended periods, JEPQ is expected to continue providing solid income with acceptable risks in the anticipated market conditions.
