How a Niche Fund Became the Biggest Active ETF -- Barrons.com

By Ian Salisbury

You might think the king of actively managed exchange-traded funds would follow a popular, big-tent strategy like buying growth stocks or Treasury bonds. In fact, the $33.8 billion J.P. Morgan Equity Premium Income ETF has grabbed more dollars than any other active ETF by plying a niche: selling covered-call options.

Covered-call funds own a portfolio of stocks, then sell out-of-the-money call options -- those with a strike price higher than the market price of the underlying stock -- to collect premium income to supplement returns. (Calls give buyers the right to buy an asset if it rises within a set period.) The strategy can generate bondlike payouts -- the J.P. Morgan Equity Premium Income ETF boasts a yield of 6.7% and lets investors benefit from rising stock prices -- but it has limits.

Given current market dynamics -- with stocks continuing to gradually drift northward while bonds post losses -- it's easy to see why covered calls have attracted fans. "We give you some dividends, some options premium, then also some upside," says J.P. Morgan portfolio manager Hamilton Reiner.

J.P. Morgan Equity Premium Income, which has seen investors pour in almost $7 billion in the past year, also has some particular features that may help its appeal within the category, notes Morningstar.

The fund's stock portfolio, which takes advantage of research from J.P. Morgan's in-house industry analysts, is designed to be well-diversified and defensive. No sector makes up more than 17.5% of the portfolio and no stock more than 1.5%. Overall, the strategy attempts to capture about 60% of the volatility of the stock market, with the aim of delivering steady returns.

To earn options premiums, managers write one-month calls on the S&P 500 index, with a strike price that's typically about 2% above the market's current price level. "The S&P 500 has enough upside and options liquidity to provide harvestable call premiums, while not being overly volatile," writes Morningstar analyst Lan Anh Tran.

Another key feature has both pros and cons: Rather than sell call option contracts in traditional options markets, the fund uses equity-linked notes designed to mimic the performance of an options portfolio. While the move simplifies tax treatment, it comes with a significant drawback, according to Tran: Call-premium income derived from notes is taxed as regular income rather than capital gains. For this reason, the fund may be better suited to investors who plan to own it in a retirement plan like a 401(k).

"I do see the rationale for them using [the notes]," says Tran, "but I don't think it's optimal." There is also counterparty risk in the unlikely event one of the note issuers fails, she says.

All in all, J.P. Morgan Premium Equity Income provides an attractive take on the covered-call strategy. But investors still need to think carefully about whether this have-your-cake-and-eat-it-too strategy really deserves a place in their portfolios.

Covered-call funds' yields may be comparable to those of bond funds, but they don't necessarily offer the same downside protection. In a bear market, the options premium should provide some cushion against losses, but beyond these, the funds have all the downsides of a stock portfolio.

At the same time, investors surrender a big portion of the stock market's upside. When Tran ran the numbers to see just how often the S&P 500 surged 2% or more in a given month -- suggesting fund investors might see at least some of their upside capped -- she discovered it happened about 38% of the time.

Those missed gains have translated into a significant lag in performance. Overall, the fund has posted a 12.2% average annual return since the ETF share class started trading in 2020. By contrast, the S&P 500 has returned 16.1% over the same period.

Write to Ian Salisbury at ian.salisbury@barrons.com

This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.

(END) Dow Jones Newswires

May 08, 2024 01:30 ET (05:30 GMT)

Copyright (c) 2024 Dow Jones & Company, Inc.