JEPY: A Generous Yield Offset By Continued Downside Risk

seekingalpha08-22

Defiance S&P 500 Enhanced Option ETF offers a high dividend yield of about 42% through the use of an at-the-money option strategy.JEPY's price stability is questionable due to its flawed fund strategy...

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The stock already experienced a 1:3 stock split.Alternative funds with out-of-the-money option strategies may offer better long-term performance and price stability compared to JEPY.   simonkr/E+ via Getty ImagesOverview This has to be one of the best times in modern history to be a dividend investor. There are so many different funds at your disposable nowadays as an income investor, and it can be hard to choose which one best suits you. Defiance S&P 500 Enhanced Options Income ETF (NYSEARCA:JEPY) an enormous dividend yield of about 42%, according to the listed rate on their site. JEPY operates as a covered call ETF that seeks high levels of income generation through its option strategy. JEPY sports a management fee of 0.99%, but this is essentially immaterial when considering the yield that the fund is kicking back to shareholders. While these newer options funds hitting the market have the allure of these ridiculously high yields, I am a bit skeptical of the long-term performance of funds that use an at-the-money strategy. An at-the-money strategy caps the upside capital appreciation potential while also providing the full downside risk to shareholders. This is why I opt for out-of-the-money option-based funds as a way to get my tiny bit of exposure to these types of funds. OTM option funds typically allow for higher amounts of price appreciation to be experienced. However, I understand that a sizeable amount of income investors interested in these types of funds don't expect any capital appreciation. The fund is still relatively new, with a public inception dating back to September of 2023. The fund's advisor is Toroso Investments and interestingly has the sub advisor listed as ZEGA Financial. ZEGA Financial is the team behind the peer Yieldmax funds that launched recently. I recently published an article on one of their funds that sports an annualized dividend yield greater than 90%. I mention this because it helps instill a bit of investor confidence that the ETF has some experienced professionals in their corner. With that in mind, let's first review the fund's strategy. Flawed Fund Strategy Unlike some other covered call peers like REX FANG & Innovation Equity Premium Income ETF (FEPI), JEPY doesn't have a diverse portfolio of individual holdings within. Instead, it maintains exposure to US treasuries. Although the fund doesn't specifically hold any equities, the underlying option strategy does provide some indirect exposure by writing put options against the S&P 500 or derivatives of it. The most recent holdings breakdown was pulled from a document last updated in May.   JEPY Q3 Holdings ReportJEPY generates the necessary income to fund the distribution by collecting the premiums it earns by selling put options. However, the fund uses an ATM option strategy, which severely caps the price movements upward while still exposing the fund to the full vulnerability of the downside. This is my main issue with JEPY because it's hard to justify a long-term position in a fund like this that will continue to deteriorate over time. In an effort to explain this as simply as possible, try to visualize the following illustration of how the fund operates. For our example, let's imagine that the S&P 500 was priced at $100. Since JEPY utilizes an ATM strategy, the fund writes an option with a strike price of $100 and the premium received for each option is $5. If the S&P 500 appreciates in value up to $110 per share, the option expires worthless, but JEPY still keeps the small $5 premium for writing the option. This is the most ideal scenario for JEPY to maintain its price level because even though the price has now grown, the distribution can be funded by the premiums received. However, the price of JEPY continues to sink because of the second scenario playing out over time. We can see that the price of JEPQ has fallen by more than 23% since the fund's inception, with almost no periods of time where the price grew. Although the total return sits above 14.7%, the trade-off doesn't seem worth it. Data by YChartsThe price decline can likely be attributed to the other scenario playing out. Keeping with the same example, let's imagine that JEPY writes an option with a strike price of $100. Instead of moving up, let's now imagine that the S&P 500 falls down to $85 per share. While JEPY would still collect its premium for writing the option, it would be forced to now swallow the loss when the put buyer exercises the option. So while JEPY would still collect its $5 premium for the option, it would have experienced a greater net loss of $10 after accounting for the premium. Therefore, the fund does provide a huge yield but at the cost of a continually decreasing share price. Not to mention, JEPY already experienced its first 1:3 stock split at the beginning of April. Comparison - Alternative Funds When comparing the price stability of JEPY against some other peer funds that use an OTM option strategy, the difference is day and night. Here are some of the better alternatives that come to mind:  REX FANG & Innovation Equity Premium Income ETF (FEPI) NEOS S&P 500 High Income ETF (SPYI) JPMorgan Nasdaq Equity Premium Income ETF (JEPQ)  Data by YChartsAlthough these funds may all have different strategies, underlying asset mixes, and option writing techniques, I believe that they will offer a much better experience over a longer period of time just because of the OTM strategy used. We can see that while these alternative funds still experience shifts alongside the market, the price stability is a lot more attractive. Since JEPY has the highest yield of this batch of peers, you may think that it naturally has the highest total return as well. When including distributions, JEPY actually has the lowest total return of the batch. Data by YChartsFunny enough, the option that provides the highest total return here actually has the lowest dividend yield of the group.  SPYI: dividend yield of 11.5% FEPI: dividend yield of 20% JEPQ: dividend yield of 9.2%  Therefore, it can be fair to say that the high distributions received are essentially offset by the continuing deterioration in share price. Is this really worth the trade-off? I think that it's all very dependent on what kind of investor you are and what sort of return you value at this stage of your journey. Dividend Yield Offset By Price Decline The distribution history is varied month to month, with the latest distribution amounting to $0.5582 per share. The next distribution is set to be announced at the end of August. Looking at the distribution history, we can see that JEPY may not the best choice if you are the type of income investor that prefers a reoccurring monthly payment that falls around the same value. During the fund's first month in the public markets, the distribution rate was $0.90 per share. Since then, we've seen some months where the payout amount was almost half of this.   Defiance ETFsWhile this isn't an investment vehicle that I am too fond of, I imagine there are still plenty of veteran option folk out there who can properly utilize a fund like this. The first group of people to come to mind are the retired investors that already have a diverse portfolio of other high-yielding assets such as REITs, business development companies, closed end funds, master limited partnerships, and so on. In situations like this, perhaps it wouldn't hurt to sprinkle in another source of high-yielding income. Since the yield is so large, it requires a lot less upfront capital to create a sizeable income source. Additionally, if you don't care to capture any capital gains or retain any principal, then maybe JEPY could be a solid choice. For instance, an investor could initiate a relatively small position and simply collect the distribution month and month until their initial investment is repaid in full. After all, the dividend yield sits above 42% so if JEPY is able to maintain this distribution payout and manage the price slide, it would take an investor anywhere between two or three years to get their initial principal back through distributions. On the initial principal is received, it gets a lot easier to dismiss the flawed pricing of this asset, since you are still collecting your monthly distribution at a gain anyways. However, this strategy assumes that no issues arise with the fund and the distributions can properly offset the price decline. If the price were to fall more rapidly than what the distributions can offset for, this theoretical timeline of two or three years to get your initial capital back could quickly double or triple if the price of JEPY slides.   JEPY Section 19a NoticeIn addition, it's worth mentioning that the distributions received from are mostly made up of the fund's net investment income. Looking at the most recent section 19a notice, we can see that approximately 60% of the distribution is funded from NII while the remaining 40% consists of the use of return of capital. Therefore, the distributions may have unfavorable tax consequences when held outside of a tax advantaged account. Takeaway  In conclusion, JEPY's use of ATM options severely caps the price upside that can be experienced while still exposing shareholders to the full effects of the downside risk. While the huge yield over 42% can be enticing, the risk is not worth it if the price deterioration ultimately chews into your total return. Option funds like JEPY will continue to underperform alternative option funds that instead choose to implement an OTM option strategy, which allows for greater price appreciation to be experienced. Therefore, I am rating JEPY as a sell because it is difficult to justify a use case for this type of fund.","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"","news_rank":0,"symbols":[],"gpt_button":0},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.1","shortVersion":"4.29.1","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2461942342"}