JEPI, JEPQ, XYLD, and QYLD ETFs have failed 2 key tests

Covered call ETFs have become highly popular among income-focused investors in the past few years, such that the industry now has over $80 billion in assets. 

The JPMorgan Equity Premium Income ETF (JEPI) leads the industry with over $33 billion. It is followed by the JPMorgan Nasdaq Equity Premium Income (JEPQ), which has over $14.8 billion. 

The other top covered call ETFs are the Global X NASDAQ 100 Covered Call ETF (QYLD) and the Global X S&P 500 Covered Call ETF (XYLD) have added over $7.9 billion and $2.83 billion in assets, respectively. 

Why covered call ETFs have become popular

Covered call ETFs have become highly popular among investors for two main reasons. First, they are known to generate substantial monthly payouts to investors, with most of them having double-digit yields that beat other dividend ETFs like the Schwab US Dividend Equity (SCHD).

JEPI yields 7.32% while JEPQ has a 9.7% yield. QYLD and XYLD yield 12% and 9,58%, respectively. These substantial yields could become more attractive when the Federal Reserve starts cutting interest rates.

Indeed, US bond yields have started coming down as expectations of rate cuts rise. Data shows that the 10-year yield stood at 3.90% while the 30-year moved to 4.22%. These yields were over 5% a few months ago. 

Second, these covered call ETFs are loved because of their approach to becoming a hedge against volatility. In other words, most investors believe that they will do well if their accompanying index retreats sharply. 

These funds aim to achieve that because of how they are created. In the first part, the funds go long on an index and then sell income-generating derivatives tied to the underlying asset.

The idea behind this is simple. In the first place, the long trade will benefit the ETF when the asset is in an uptrend. At the same time, the ETF benefits from the options part of the trade protects and provides income. 

For example, assume that an asset was trading at $10 and you place a call trade with a strike price of $11.5. This call trade gives you the right but not the obligation to buy an asset. If it drops to $9, then you won’t execute the call option since you can buy it cheaply in the open market. 

If the stock rises to $11, you can execute the call option and take the profit. However, your gains will be capped at $11, meaning that your call option trade will not benefit if it rises to $12. By selling the call option, these funds also generate some income, which they distribute to investors.

JEPI, JEPQ, QYLD have lagged the market

As I have written before, while covered call ETFs are relatively new, their current data shows that they underperform their respective assets. JEPI has underperformed the S&P 500 index while single stock covered ETFs like TSLY and NVDA have underperformed Tesla and Nvidia, respectively.

These funds have lagged the benchmark assets despite their high advertised dividend yield. JEPI’s 7.5% yield is higher than that of ETFs that track the S&P 500 indices like the VOO and SPY. 

The second important test happened on Monday when American stocks crumbled amid rising fears of the unwinding Japanese yen carry trade. In this case, these funds should have outperformed the key indices like the S&P 500 and the Nasdaq 100.

However, data shows that their outperformance was minimal. That performance happened because the small gains generated in the options market was not big enough to offset the sharp decline in stocks. 

On Monday, the JEPI ETF dropped by 2.8%, slightly better than the S&P 500 index’s 3%. The same trend happened across other covered call ETFs. In a note, an analyst told the FT that:

“These funds don’t like volatility. They call it an income strategy, but really you’re just selling volatility. That can work out for long periods but can get completely hammered when you have a severe crash.”

This view was confirmed in 2022 when the JEPI ETF outperformed the S&P 500 index by a wider margin. As shown above, the index dropped by 20% between January 1st and December 31st of that year. JEPI’s drop was more modest at minus 2.5%. 

The same happened in the Nasdaq 100 index, which crashed by over 26% while the JEPQ ETF dropped by 12%. 

This performance means that investors should not expect a positive return when the underlying indices are tanking.

In the long-term, however, as shown above, the total return of these covered calls has underperformed the market by far. In this chart, we see that the JEPI and XYLD ETFs have risen by 19.4% and 10.70%, respectively, while the basic SPY has risen by 26%. 

Similarly, the QYLD ETF has risen by 28% and 8% while the Invesco QQQ fund has risen by 24.5%. The JEPQ’s total return of 28% was better than that of QQQ. This view was confirmed by a Morningstar analyst who said:

“I always maintain that for a long-term investor, it’s not a buy-and-hold investment. You’re giving up a lot of upside, and compounded over the long term, that’s not a good proposition.”