This ETF’s secret for sustainable income isn’t dividends

J.P. Morgan Asset Management's Hamilton Reiner spills all on the process behind the JPMorgan Equity Premium Income ETF (JEPI).
Hans Lee

Livewire Markets

Dividends are a way of life for many Australians. Even if you're not an income investor, there's nothing quite like that injection of bonus cash into your account. But income doesn't always have to equal big dividend payout ratios - far from it.

As Hamilton Reiner of J.P. Morgan Asset Management explains, the best way to generate sustainable returns is one that reduces risk and cancels out poor-quality options.

In this Fund Manager Q&A, Hamilton joins me from New York to discuss the ETF's approach, the instruments it uses to generate returns for its investors, and why dividends are not a prerequisite for his team's investments, despite being an income-generating ETF.

Hamilton Reiner, J.P. Morgan Asset Management

About the ETF

JEPI was initially launched in the US in May 2020 and, in less than three years, has become the largest actively-managed equity ETF in the world, according to data sourced from Morningstar, with an Australian version of JEPI now available on the ASX (ASX: JEPI).

As of writing, the ETF has 116 stock holdings and all of these are listed in the US. Some of its largest positions include insurer Progressive (NYSE: PGR), payments giant Mastercard (NYSE: MA), and beverage behemoths Coca-Cola (NYSE: KO) and PepsiCo (NYSE: PEP)

Reiner says the Fund's current make-up is priced and prepared for any US-led recession.

"When we think about our underlying portfolio, it's already pricing in some type of recession," Reiner says.

"If we go into a recession, I would anticipate market volatility will go up which is a tailwind for us. Higher levels of volatility correlate to higher levels of income that JEPI can generate."

Who is this fund for? 

"I think the strategy fills a need. It does some unique things. For income-oriented clients, it gives them an above-average level of income. For total return clients, it gives them a concerted exposure to equities through dividends and some options premium giving you some upside and does it with a lot less volatility and beta," he says.

Reiner also attributes a lot of the success to his team including fellow portfolio manager Raffaele Zingone and their 21 analysts.

"I'm pretty darn spoiled," Reiner admits.

The secrets behind the Fund's strategy 

The ETF itself uses two main building blocks. Part of the strategy is a long-term, underlying portfolio, that employs a bottom-up, stock-specific approach.

"We're looking for those stocks with less price volatility and less earnings variability," Reiner says. "The resulting portfolio tends to have a higher quality footprint."

Importantly, this part of the strategy is deliberately style-agnostic. It's a valuation-centric model which is designed to find companies that have predictable earnings.

The other part is an options overlay.

  • An option is a contract that provides a buyer with the right, but not the obligation, to buy or sell a specific financial product known as the option's underlying instrument. For equity options, the underlying instrument is a stock, index, ETF or similar product. The contract itself is very precise. It establishes a specific price, called the strike price, at which the contract may be exercised, or acted upon. Contracts also have an expiration date, a period that could be as short as a day or as long as a few years. When an option expires, it no longer has value and no longer exists.
  • If investors buy a call, they have the right to buy the underlying instrument at the strike price on, or before the expiration date. On the other hand, selling a call option gives the seller the obligation to sell the underlying instruments at the strike price (Source: Basic Options Terms Explained: In-the-Money, At-the-Money, and Out-of-the-Money”, The Options Industry Council, January 2023). In return, the seller is paid a premium.
  • A call option is in-the-money if the current market value of the underlying stock is above the strike price of the option. The call option is out-of-the-money if the stock is below the strike price. For example, if a stock is trading at $50 per share, while the investor has a strike price at $70 and owning a $70 call, that option would be out-of-the-money by $20.

Reiner’s team employ a covered call strategy which comprises selling S&P 500 Index call options while owning a defensive portfolio of US large cap stocks. This provides a small hedge on the equity and allows an investor to earn premium income without taking on additional risk, in return for temporarily forfeiting some of the stock's upward potential.

The premium received adds to the investor's bottom line regardless of outcome. It offers a small buffer in the event the market slides downward and can help boost returns when it rises. By rolling a portion of the call options weekly, this also allows the team to adapt to changing market conditions.

Reiner is quick to point out that his team does not use leverage as a tool.

"People think options are scary or they put people in harm's way. No one's ever headlined the Wall Street Journal for using options in an unlevered manner," Reiner says. "We use our options in a way that farmers, oil companies, and airlines do."

In other words, the options are used either to hedge prices or lock in a favourable price.

Finally, he notes that selling call options on the S&P 500 rather than against any individual name reduces beta while ensuring the portfolio keeps the winning holdings.

"My clients are comfortable saying we know what we may give up but we do know what we're getting today," he says.

Surprising holdings in the Fund: Microsoft (NASDAQ: MSFT) and Google (NASDAQ: GOOGL)

In the first list of names I revealed, you'll notice there is a highly defensive bent among them (which speaks to the earnings predictability theme). But a closer look at the portfolio also reveals some holdings which are not akin to an income-centric approach.

So why does the fund hold them?

"Dividends do not come into our stock selection. We're looking for great names to own and when the market sells off, those names tend to hang in better" Reiner says.

This is when Reiner reveals that 10% of the portfolio does not pay a dividend.

"There are a lot of great names that don't pay a dividend and we're going to own them. We're not going to have a screen that says you cannot own stocks that don't pay dividends," Reiner says. 

What's the biggest change in markets?

Reiner and his partner each have over 30 years of market experience. So what does he believe is the biggest change in financial markets over that time?

"The dissemination of information is so much quicker," he says. "There are no longer any secrets. Everyone used to wait for things to get published. Nowadays, it's 24/7. So those of us with the depth and breadth of our analyst teams will have an information advantage."

JPMorgan Equity Premium Income (JEPI)
Global Shares

Find out more

The actively managed JPMorgan Equity Premium Income ETF (JEPI)1 pursues opportunities for consistent monthly income and appreciation, with lower volatility than the U.S. stock market. 

Click here for more details.

(1)JPMorgan Equity Premium Income (JEPI) is the marketing name of the JPMorgan Equity Premium Income Active ETF (Managed Fund). This information is generic in nature and does not take into account any specific investors’ objectives and should not be treated as offer, research or investment advice. Investors should seek financial advice. Past performance or distributions is not a guide for current or future results. The Australian registered JPMorgan Equity Premium Income Active ETF (Managed Fund) is a locally managed fund and it’s performance will differ from the underlying fund due to the impact of fees, taxes, currency fluctuation and other factors applicable to the Australian fund which are set out in its Product Disclosure Statement and Target Market Determination (available on Investors should review these to understand the various risks associated with investing in the Fund and in making any investment decision. Risk management does not imply elimination of risks. Provided to illustrate the investment process. Dividend or returns are not guaranteed. Please refer to offering documents for details on distribution policy. ETFs have fees that reduce their performance, indexes do not. Investors cannot directly invest in an index. The Fund seeks to achieve its stated objectives, there is no guarantee they will be met. Dividends or returns are not guaranteed. Returns assume that an investor purchased units at Net Asset Value and does not reflect the transaction costs imposed on the creation and redemption of units, brokerage or the bid ask spread where applicable that investors may pay to buy and sell units on the Australian Securities Exchange. Information is considered correct at the time of issue but no liability for errors or omissions will be accepted by JPMorgan Asset Management (Australia) Limited or its affiliates. Livewire gives readers access to information and educational content provided by financial services professionals and companies (“Livewire Contributors”). Livewire does not operate under an Australian financial services licence and relies on the exemption available under section 911A(2)(eb) of the Corporations Act 2001 (Cth) in respect of any advice given. Any advice on this site is general in nature and does not take into consideration your objectives, financial situation or needs. Before making a decision please consider these and any relevant Product Disclosure Statement. Livewire has commercial relationships with some Livewire Contributors.

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Hans Lee
Senior Editor
Livewire Markets

Hans is one of Livewire's senior editors. He is the creator and moderator of Livewire's economics series "Signal or Noise". Since joining Livewire in April 2022, his interview record includes such names as Fidelity International Global CIO Andrew...

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