Benzinga - by Austin Hankwitz, Benzinga Contributor.
Introduction 2023 was a year that took many by surprise, including myself.
The S&P 500 Index (ARCA:SPY) returned a total of 26.3% — carried higher by the outperformance of the Magnificent Seven. However, this 26.3% total return didn't come without a fair share of volatility — as the S&P 500 Index fell -10% over a three-month period during the latter half of 2023.
With that being said, there are many investors (including myself) who would prefer a more stable and predictable return — with income in mind.
In this post, I'm going to compare the total return of the three most popular S&P 500 Index covered call ETFs in an effort to better understand why the JPMorgan Equity Premium Income ETF (ARCA: JEPI) performed so poorly in 2023 — as well as make a prediction for 2024.
2023 In Review If you're an income investor like me, your portfolio is anchored by covered call ETFs that are benchmarked against the total return of the S&P 500. Unfortunately, 2023 proved not every S&P 500 covered call ETF is made equal.
Now, before you all come after me with comments like "You can't compare JEPI to the S&P 500 Index! JEPI doesn't hold the same stocks, it's a completely different strategy!"
You're right. However, the fund's investment objective as shared in their summary prospectus states the following:
"The investment objective of the Fund is to seek current income while maintaining prospects for capital appreciation.
The Fund seeks to achieve this objective by (1) creating an actively managed portfolio of equity securities comprised significantly of those included in the Fund's primary benchmark, the Standard & Poor's 500 Total Return Index (S&P 500 Index)..."
And as shown here on Morningstar, JEPI's benchmark index is the S&P 500.
Now that we're all on the same page, let's dive into the numbers, starting with JEPI.
JPMorgan Equity Premium Income ETF Facts The total return of JEPI in 2023 was 9.8%, capturing only 37% of the total return of the S&P 500 index.
As we all know, the S&P 500 Index was led higher in 2023 by the Magnificent Seven — seven stocks JEPI's fund managers understandably decided to leave out of the fund's holdings throughout the year. Only two of those seven names, Microsoft Corporation (NASDAQ: MSFT) and Amazon.com, Inc. (NASDAQ: AMZN), were held by the fund in 2023.
As stated in the summary prospectus, "The Fund seeks a lower volatility level than the S&P 500 Index." JEPI certainly achieved this, as the price of their shares only slipped -7.8% during the -10% drawdown the S&P 500 experienced between the months of August and October of 2023. And when you add monthly distributions to that figure, risk-averse investors become increasingly happier — a win in my book.
However, it's equally as important to ask yourself the question "Is the return I see the return I get?"
JEPI uses Equity Linked Notes (ELNs) to generate monthly income for their investors. In the eyes of the IRS, the income generated by these ELNs are taxed as ordinary income — meaning after taxes, this 9.8% figure might be materially lower for some folks depending on their tax brackets.
As a fellow JEPI investor, I'm constantly weighing my opportunity cost. By choosing JEPI over the next best thing, I'm capturing only 37% of the S&P 500's total return. Sure, I'm doing so in an effort to smooth out the volatility of my portfolio while also generating monthly income — but at the expense of upside potential and higher taxes.
Let's move on.
Global X S&P 500® Covered Call ETF Facts The total return of XYLD (ARCA: XYLD) in 2023 was 11.0%, capturing only 42% of the total return of the S&P 500 Index.
XYLD was able to marginally outperform JEPI by 1.2% as the fund held "all the equity securities in the S&P 500 Index in substantially similar weight."
But, if XYLD held the Magnificent Seven inside of their fund, why did it only capture 42% of their S&P 500's total return? I thought the Mag Seven was the reason the S&P 500 performed so well?
They were.
But, unfortunately for my fellow XYLD investors because the fund wrote at-the-money (ATM) covered calls against their holdings, their total upside was capped at just the premium generated by the option contracts. Here is a link to review XYLD’s holdings as of 4/15/24 — which also displays their “Upside Cap Details.”
According to XYLD's summary prospectus (emphasis added):
"The Fund writes a single "at-the-money" call option, which is when the strike price is near to the market price of the underlying asset, as determined on the monthly option writing date of the Underlying Index in accordance with the Underlying Index methodology.
The Fund's covered call options may partially protect the Fund from a decline in the price of the Reference Index through means of the premiums received by the Fund. However, when the equity market is rallying rapidly, the Underlying Index is expected to underperform the Reference Index."
And underperform it did.
However, unlike JEPI, XYLD uses Section 1256 contracts to generate their monthly income for investors. These Section 1256 contracts are treated much more favorably than ELNs in the eyes of the IRS — with income to be taxed as 60% long-term capital gains and 40% short-term, allowing investors to keep more of that 11.0% yield come tax time in April.
Neos S&P 500(R) High Income ETF Facts The total return on SPYI (BATS: SPYI) in 2023 was 18.1%, capturing nearly 69% of the S&P 500 Index's total return.
SPYI was able to materially outperform both XYLD and JEPI in 2023 by 7.1% and 8.3%, respectively. SPYI was able to do this by "investing in a portfolio of stocks that make up the S&P 500 Index," while also implementing a covered call option strategy that wrote out-of-the-money covered call option contracts.hoose
Let's take a look at SPYI's holdings (as of 4/15/24) to get a better understanding as to why this covered call ETF outperformed its competitors by such a wide margin.
As you can see hyperlinked above, the management team behind SPYI decided to write two covered call option contracts against the S&P 500 expiring on May 17 at the strike prices of 5,350 and 5,405. Assuming these contracts are rolled every 4-to-6 weeks, something SPYI's management team has stated in multiple interviews, they were likely written early-April.
The S&P 500 Index was trading around ~5,220 during this time frame — which means their management team wrote these options contracts 2.5% and 3.5% out-of-the-money. These percentage points might not seem like a big deal, but when we have weeks like we did when these contracts were written (new all-time highs in the S&P 500 Index), writing out-of-the-money contracts vs. at-the-money contracts can move the needle from a total return perspective.
For added perspective, shared here are XYLD's covered call option contracts (as of 4/15/24) — choosing to write option contracts at the 5,135 strike price. Just last week, the S&P 500 Index was trading around 5,200 — which means XYLD investors weren't capturing any upside beyond 5,135. At the time of writing, the S&P 500 Index has fallen back down to 5,050 — putting XYLD investors back in the money. Hard to say how long that might last.
Similar to XYLD, SPYI uses Section 1256 contracts to generate their monthly income for investors — allowing them to keep more of that 12.16% annual distribution yield in their pockets when Uncle Sam comes knocking.
All in all, SPYI offered strong outperformance against XYLD and JEPI in 2023 — both from an income generation and tax-efficiency perspective.
JEPI paid out $4.62 per share last year, an 8.4% yield against their $54.98 closing price on December 29, 2023. XYLD paid out $4.15 per share last year, a 10.5% yield against their $39.44 closing price on December 29, 2023.
SPYI paid out $5.80 per share last year, a 12.0% yield against their $48.20 closing price on December 29, 2023.
Don’t Make The Same Mistake Two Years In A Row 2024 is shaping up to be much of the same — the S&P 500 continues to make new all-time-highs, the Federal Reserve is now projected to cut interest rates three times before year-end, and inflation is continuing to subside.
We’re officially three months into the calendar year, giving us an opportunity to check in on the performance of the above-mentioned S&P 500 covered call ETFs — let’s kick things off with the JPMorgan Equity Premium ETF.
According to Morningstar, JEPI’s Q1 total performance was 6.36% — this included 4.3% of price appreciation ($54.88 to $57.27).
So far, so good — right?
Moving on to the Global X S&P 500 Covered Call ETF — according to Morningstar, XYLD’s Q1 total performance was 5.86%. This included 3.6% of price appreciation ($39.36 to $40.77).
It seems that during Q1, XYLD underperformed JEPI by -0.5%.
Finally, the NEOS S&P 500 High Income ETF’s Q1 total performance, according to Morningstar, was 7.67% — this included 4.5% of price appreciation ($48.12 to $50.33).
SPYI has outperformed JEPI and XYLD by 1.31% and 1.81%, respectively, during the first quarter of 2024. And it makes sense that SPYI experienced higher price appreciation than its peers during the same period of time. Because they wrote out-of-the-money covered call option contracts, SPYI’s share price was able to appreciate as the S&P 500 Index traded to new all-time-highs throughout February and March.
Despite JEPI’s total performance in Q1 being “only” 1.31% below SPYI’s, this doesn’t take into account their Equity Linked Notes — a very tax-inefficient way to generate income for shareholders. After considering income taxes, SPYI’s Section 1256 Contracts further solidify the fund’s outperformance relative to its peers.
To put all of this in perspective, the S&P 500’s total return during Q1 was 10.40%. This means XYLD only captured 56.3% of the S&P 500’s total return during Q1, JEPI only captured 61.1%, while SPYI captured over 73%.
If calendar year 2023 and the first three months of 2024 have proven anything to us, it’s that SPYI’s covered call strategy is superior to its peers — especially if you care about price appreciation, income, and tax efficiency.
So if you’re looking for a covered call ETF that offers consistent monthly income and the ability for long-term capital appreciation generated from the S&P 500’s constituents, don’t make the same mistake two years in a row.
Disclaimer: This is not financial advice or recommendation for any investment. The content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice.
Austin Hankwitz is a writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking. In some circumstances, he has a business relationship with a company whose stock is mentioned in this article.
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