The ETF Edge In an Uncertain Market

2024 is an exceptionally opaque year in terms of the markets.

The rate path for the worlds’ central banks remains shrouded in mystery; the risk of a regional conflict in the Middle East is growing; and more than 2 billion people across 50 countries are going to the polls. Uncertainty is the only thing to be sure of.

It will be a year marked with increased volatility that will inevitably test last year’s bullish predictions. Equity markets were resilient in 2023, but the rally has left investors feeling uneasy about what to do next.

“Many are wondering if they’ve ‘missed it’ and are sitting on cash trying to figure out when to enter the market,” says Hamilton Reiner, head of the US Equity Derivatives team at J.P. Morgan Asset Management. “Yet one of the biggest risks facing investors is not putting their money to work.”

Facing so many unknowns, investors want a differentiated way to generate returns in equities. To many investors that want to strike the right balance between regular income and total return, covered call exchange traded funds (ETFs) have been the answer.

Covered call ETFs sell options on underlying equity holdings to generate income in the form of option premiums while also limiting the magnitude of gains or losses.

So popular are these covered call ETFs that they now roughly contain USD59 billion in combined assets, up from only USD3 billion three years ago, according to Morningstar Direct.(1)

One of the biggest benefactors of this trend is the JPMorgan Equity Premium Income (JEPI)  Strategy. Listed as an ETF in both the US and in Australia on the ASX, JEPI has seen a remarkable rise since its launch in May 2020 in the US (the Australian ETF was listed in Nov 2022).

The ETF is the largest actively managed ETF with USD 30.54 billion in assets under management at the end of 2023. (Source: Bloomberg as of 31 Dec 2023). One of its main appeals is the combination of both income and total return but at a lower volatility profile compared to the S&P 500 Index.

JEPI has two building blocks: a higher quality, defensive underlying equity portfolio benchmarked to the S&P 500 and an options overlay strategy which consist of selling out-of-the-money call options. But unlike other covered call strategies that sell single security options, which can result in stock winners being sold and stock losers being kept — these call options are index-linked.

The option premium is then converted into a coupon using equity-linked notes, which allows the distribution of bona-fide income on a monthly basis without return of principal.

JEPI is willing to forgo some upside in exchange for a steady monthly income, without using leverage or taking interest rate or duration risk. Additionally, the income generation through the options premium benefits from higher volatility, which increase the income potential when investors most need the buffer against fluctuating market prices.

For example, in 2022 when stock and bond indexes fell sharply, JEPI only lost 3.5% while the S&P 500 fell 18% - this is down to the fact that it holds a more defensive portfolio and the manager’s focus on delivering consistent income through the options overlay.

According to the Global ETF Survey 2023 by Trackinsight, professional investors are turning to the power of ETFs to execute increasingly sophisticated, innovative, and incisive strategies that can generate attractive returns as business conditions become more challenging.(2)

“We like to use JEPI as it provides our clients with a diversified exposure to high quality US equities” says Candice Bourke, a Senior Investment Adviser at Shaw and Partners. “Due to the low transaction costs; lack of expiration dates; day trading abilities and greater diversification, ETFs are an easy option to take a leveraged position on an index.” Bourke adds, “We also believe with over 40% of the globe’s total GDP heading to the voting polls in 2024, this uncertainty surrounding political outcomes could lead to increased market volatility, which we expect JEPI will perform in both the upside and downside scenarios given its unique investment approach.”

And for those investors that are looking for a higher exposure to certain themes or sectors, different types of ETFs should be considered being used in unison. For example, a blended mix of 60% JEPI and 40% of the JPMorgan US 100Q Equity Premium Income Active ETF (JPEQ), which is benchmarked to the Nasdaq 100, can provide investors with a broader exposure to growth-oriented stocks.

“If the market rally persists, the funds will capture some of the upside with lower volatility. But if there’s a sell-off, higher volatility may provide elevated levels of income,” says Reiner, portfolio manager of both JEPI and JPEQ, with over 37 years of experience. “And if we see a choppy market that’s more rangebound, the income derived from options should help to generate healthy returns.”

While ETFs in Australia are not as widespread as the US and Europe, they are undoubtedly growing in popularity.

Some 20% of respondents embraced the convenience of ETFs, up from 15% in 2020, says the Australian Investor Study 2023 by the Australian Securities Exchange (ASX).(3)

ETFs are one of the most affordable ways to enter the investment market and are becoming more appealing to all investors: from retail to high-value investors and those with self-managed superannuation funds.

This trend is likely to continue, specifically for active ETFs, where demand is expected to increase over the next two to three years, according to a report entitled ETFs 2027: A World of New Possibilities from PWC.(4)

Against the backdrop of severe market uncertainty in 2024, JEPI and JPEQ are an accessible and affordable investment option, guided by Reiner and the insights of over 20 experienced US equity career analysts.

“The cornerstone of our approach is our dedication to global research,” concludes Reiner. “Our extensive expertise in markets around the world, and collaboration across regions and sectors helps us uncover truly compelling opportunities.”

(1) https://www.ft.com/content/619312b1-15c8-48c8-95d8-09cdeae95956
(2) https://www.trackinsight.com/global-etf-survey/2023
(3) https://www.asx.com.au/investors/investment-tools-and-resources/australian-investor-study
(4) https://www.pwc.com/gx/en/financial-services/publications/assets/etf-2027-report.pdf

Investments involve risks. This material is issued by JPMorgan Asset Management (Australia) Limited (ABN 55 143 832 080) (AFSL No. 376919).