It won’t work nearly as consistently as you might like.
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High-yield exchange-traded funds (ETFs) aren’t exactly new, including ones that generate income by selling — or “writing” — options on the stocks held within the fund. As the market becomes less predictable and more difficult to navigate, though, income-producing investments that generate lots of immediate cash are becoming very popular, and understandably so. Once this cash is in your proverbial pocket, it’s no longer at (much) risk of unexpectedly losing value.
As is always the case with any investment, however, these particular investments come with a downside that must not only be understood but also managed.
A well-funded individual investor recently asked an entire Reddit community what it thought about a plan to invest $4 million in a trio of high-yielding ETFs, two of which regularly use the aforementioned strategy of selling call options on stocks the funds already own.
Will this actually work? What Am I missing?
by u/Ddash-3 in dividends
Here’s an answer highlighting some other important details that similarly minded investors may want to consider before plowing into this plan.
What does “writing” covered calls mean?
What does it mean to sell covered call options?
A call option is a bet that a particular security or index will be at or above a specific price by a specific point in the future. As is the case with any bet, though, you pay to make it.
Call options — like their bearish counterpart “put” options — are also securities in and of themselves, and are bought and sold at ever-changing prices that reflect the market’s ever-changing assumptions about their value. As with most stocks, you don’t actually have to buy an option first to sell it at a higher price later. You can sell or “write” an option you don’t already own and collect the cash proceeds, and then buy or “cover” that trade later at what’s hopefully a lower price.
In JPMorgan Chase‘s case, with its JPMorgan Nasdaq Equity Premium Income ETF (JEPQ 0.26%) and its JPMorgan Equity Premium Income ETF (JEPI 0.46%), the plan isn’t to buy the call options it’s selling back at a later date. The goal is largely to let that option expire altogether, which effectively closes out the position with a buy price of nothing. All the initial sale proceeds become profit.
But what if the call in question gains in value before it expires? JPMorgan is “covered” in the sense that it already owns shares that it can deliver if the call options it writes are exercised against it. (A call option is also a contract to deliver shares of a particular stock, after all, if the buyer of that call so chooses.) Fund managers can also exit short-term option trades at a loss and just move on to the next one.
For both of these ETFs, this option-selling is constantly happening, generating cash flow that’s dished out to investors on a monthly basis. As of the latest look, JEPQ’s annualized payout yield stands at 14.5%, while JEPI’s is an impressive 11.4%. Not bad. You can certainly see why this investor likes the idea of leaning into these two ETFs with his $4 million.
These funds aren’t without their downsides, though.
Here’s the rest of the story
Writing covered calls isn’t a strategy that consistently beats the market in the long run. It just monetizes the market’s long-term growth by converting what would have otherwise been capital gains into tangible cash. Even then, it doesn’t completely keep up. As the chart below illustrates, despite its big dividend payments since its launch in mid-2022, the total return on the JPMorgan Nasdaq Equity Premium Income ETF still lags its benchmark Nasdaq-100 index.
Data by YCharts.
The JPMorgan Equity Premium Income ETF’s net performance has been just as disappointing compared to its benchmark in the S&P 500 since its inception in 2020.
Data by YCharts.
It’s also worth noting that while the annualized yields on both funds are currently sky-high, that’s based on dividends that haven’t exactly grown … or even been consistent. Our investor’s plan to invest $17,000 worth of excess monthly investment income into the Vanguard S&P 500 ETF (VOO 0.50%) may be challenged by the sheer inconsistency of these two ETFs’ dividend payments. In some months, it could be even less than the $10,000 the investor needs to live on.
Data by YCharts.
Blame the strategy of selling call options on stocks you already own, mostly. It works better some times than others, and sometimes, it doesn’t work at all. Covered call strategies notoriously underperform when the market is rallying the most, for instance, by bolstering the value of the call options you’ve already sold that you now want to lose value.
Also note that neither of these funds is particularly tax-friendly, by virtue of perpetually generating a fair amount of taxable income. In this vein, our investor didn’t clarify how much of that $4 million was in an IRA, or how old they are. Some of that presumed $27,000 in monthly investment income could be subject to taxation, though, and that assumes the investor won’t also be penalized for making early withdrawals from retirement accounts. This will reduce the total amount of net income the investments are generating.
Making the good idea better
So why would anyone want to own either of these two ETFs, or any like them?
Don’t dismiss the value of owning an income-producing investment, even if that income can be inconsistent, or even if your net performance ultimately lags that of the overall market. Bonds underperform stocks too, but they still have their place in plenty of people’s portfolios.
The inconsistent income that the JPMorgan Nasdaq Equity Premium Income ETF and the JPMorgan Equity Premium Income ETF offer doesn’t make them a great option for investors who need predictable cash flow. If you’ve got enough accessible cash to smooth out the rough edges, however, these two funds have their place, too.
The basic premise is reasonable enough as long as you know that exchange-traded funds like the JPMorgan Nasdaq Equity Premium Income ETF and the JPMorgan Equity Premium Income ETF will ultimately underperform their benchmarks despite their strong yields. They’re not growth investments. They’re income investments, and they do that job nicely, even if not consistently.
In this instance, however, accepting a little less real-time cash return in exchange for far more predictable cash flow makes sense. While it will be tough to match the big yields that JEPI and JEPQ currently boast, you can get reasonably close with alternatives like preferred stocks and higher-yield “junk” bonds that would dramatically diversify this investor’s holdings.
Image source: Getty Images.
A bit more exposure to the Schwab U.S. Dividend Equity ETF (SCHD 0.11%) already in the hypothetical portfolio would help, too. It’s yielding just under 4% right now, which isn’t much compared to JEPI and JEPQ. But it’s a yield based on dividend payments that are much more consistent. And predictability means a lot when your portfolio needs to perform a minimum way right out of the gate.
This particular investor may also want to consider positioning for a little more capital appreciation that can’t happen with the current plan. The investor didn’t mention their age, but if they’re going to live another 15 years or more, inflation and a couple of unexpected black swan events could take a sizable bite out of their future buying power. Diversifying the kinds of strategies they’re using will help just as much as diversifying the kinds of stocks they’re holding.
Bottom line? There are no market-beating tricks in the long run. Successful investing is still largely a game of patience won by people who know and understand all their risks and manage them accordingly with diversification.
