Talk Your Book: J.P. Morgan's Covered Call Strategies

0:00Today's Animal Spirits Talk Your Book is brought to you by J.P. Morgan Asset Management. Today, we're talking about the J.P. Morgan Equity Premium Income ETF, ticker JEPI. If you want to learn more, check out all the links in the show notes and go to J.P. Morgan Asset Management to learn more. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions.

0:37Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

1:01to sell in value. Lack of liquidity may also cause the value of an ELN to decline. Since ELNs are in note form, they are subject to certain debt securities risks, such as credit or counterparty risk. Should the prices of the underlying instruments move in an unexpected manner, the fund may not achieve the anticipated benefits of an investment in the ELN and may realize losses, which could be significant and could include the fund's entire principal investment. Welcome to Animal Spirits with Michael and Ben. Michael, we got this email from someone last year, kind of tongue in cheek, but I think that there was some truth into it.

1:33At what yield do you put all your money into ticker Jeppy? At what yield do you put all your margin into Jeppy? At what yield do you mortgage the home and put all that money and margin on Jeppy? Was it Hamilton who sent that? This was an actual email we got at the end of 2022. Hamilton is the name of the portfolio manager that we had on the call. Yeah. The JP Morgan equity premium income ETF, which I guess I should have known this. I didn't. This is the largest active ETF that there is by assets. It's almost$30 billion in assets. It's still relatively new, only a couple of years old. It's a covered call strategy that also invests in low volatility stocks and high quality stocks.

2:09And this thing has just been raking in the money. And a lot of people really like it for the fact that there's lower volatility in the market and it has a yield from the covered call options. I wonder what percentage of people in this strategy are A, in or near retirement, be actually using the income. I would say for the first part, if I had to guess, I'm going to say, again, I'm just completely making this up. 75 % of the money in here is for people over the age of, say, 55. But I also bet you that a relatively small number of investors are actually taking the money, the income and living off of it.

2:51I think people, psychologically, investors love the idea of steady income, even if they're not using it, even if they're not spending it. And they mentioned that they pay the money out on a monthly basis. So it's like you're receiving, you're right, an income from your investment. But do you agree with my assessment? Yes. If you have to guess what percentage of people are using the monthly income for spending, do you think it's a small percentage? Probably a pretty decent amount. Just like having that, and then I'm leaving the principal alone and I'm living off the income or whatever. I think a lot of people have that mindset.

3:21Oh, yeah. Okay. Because I would say a small number of people are using the income. Okay. You think it's just investors who like the strategy? I think it's investors. That makes sense. I'm guessing that there's a lot of advisors in this too. So we talked to Hamilton Reiner, who's a portfolio manager and helped create this strategy and great talk. I think our analyst, Sean, said that he would have bought used paper from him. This is a very good, engaging conversation. Here's our talk with Hamilton.

3:52We are joined today by Hamilton Reiner. Hamilton is an MDPM and head of US equity derivatives at JPM Asset Management. Hamilton, welcome to the show. Thanks for having me, guys. Truly appreciate it. We get a lot of questions in our inbox from people. Sometimes they're broad market-based, sometimes they're specific to a fund. And I think the fund we've gotten the questions about most in the past 18 to 24 months is JEPI, which is JPMorgan's covered call strategy, ETF. And there's a lot of people who love this strategy and want to learn more. So I think We're excited to have you on today. Maybe just give a broad overview of the strategy, how it was created, and kind of the process for stock selection and how the cold cover call thing works.

4:35Absolutely. So my background is 35 years of investing in equity and equity options. And when I first joined JPMorgan Asset Management, the idea was how can I actually do options in a delivery mechanism that can actually make it more widely used? So with JEPI, our goal was actually to try to find a way to do call overriding, but do it in an ETF so that the masses could actually invest in it. When I think about traditional call overriding strategies, oftentimes people work really, really hard to go out and find their favorite stocks and then sell calls on their favorite stocks. And they end up rooting against themselves where they're saying, I hope it goes up, but not too much.

5:13I mean, imagine thinking about that as an investor. or you end up having your winners taken away from you and you're left with your losers. So when it comes to the call overriding component, we actually like selling options at the index level. That way we get to remove beta to get the income, but never have our stocks taken away from us. Hamilton, can we explain the basics of a covered call? Let's say that somebody owns Apple. They own a lot of Apple. And for whatever reason, it could be a million reasons. They want to generate some income. they want that, you know, maybe they have a near term bearish view, wherever the option, the strike is at or the maturity.

5:52What are the mechanics behind a covered call? Just basics. How does it work? So traditionally the way a covered call strategy works is you own a stock and then you sell an option. And as you said, Michael, it could be because you'd sell some of that stock at a higher level anyways. You would feel like maybe it's dead money and you'd just feel like you can generate some income short term. But historically, you own an underlying stock or an index, and then you sell an at the money or out of the money option on that same stock or index. The challenge, though, is, as you folks know, everyone will sell a stock of 10 % until it goes up 10%.

6:32And they're like, I never thought it would get there. And then they feel like, well, why did I sell this call? I need to buy it back. And you end up locking in a loss. because oftentimes when you actually sell that out of the money call, it does create a tax event because if you deliver your shares, you now have a taxable event. So traditional call operating is you own a security, you sell an option on that security, Michael. So the way that options are priced is one of the big components is volatility. I think this is one of the reasons that so many people like to do call options, sell call options on individual securities because most or many securities, I guess, are more volatile than the market.

7:10meaning maybe they can pick up a little more money over selling those options on the market, but you do it against the market. So obviously, the stock market itself is never predictable, but does that make your income stream a little more predictable than it would be if you were doing it on individual securities? So the reason we do the index is because we think that there's value in our stock selection, and we never want to have our stocks taken away from us. And as you know, JEPI is expected through a cycle to give our investors 7 % to 9 % distributable income. And that's doing options on the index.

7:40Yes, if I did options on individual names, it could be more income. But the risk of having those stocks taken away from us significantly outweighs that modest amount of income. And to be quite frank, no one's ever really complained about 79 % distributable income. So there's two components of the strategy. There's the income that you receive from selling the calls. And then there's the active component. So we'll get to the stock selection. But before we do that, I just want to spend another minute on the calls that you're selling. I assume that this is formulaic and that there's not too much discretion or maybe I'm wrong.

8:12How does it work? Are you laddering this out? Is it just you continue to roll? How does the options selling strategy work? So when I think about the approach we take from an options lens, there's a couple of things that are part of my investing philosophy. Number one, it's not just about income. It's about total return. So we always sell out of the money options, Oftentimes, people sell an at-the-money option for going all the upside. We want to get balanced to our portfolio, some upside and some income. The other thing that I think is important is you need to have some type of flexibility based upon market environments.

8:49So if you always sold an at-the-money call or you always sold a 2 % or 5 % of the money call, those are not always the same animals. I guess the word animals means a lot talking to you guys. But when I think about the market environments, a 2 % of the money call is different if the vol is 16 versus 24 versus 32. So the approach that we take is we sell an option that has a 30 % chance of finishing their money or a 30 delta option. So when market volatility is average, let's call it that 16 to 18, we're going to actually sell calls about 2 % of the money. But when volatility is elevated like it was last year, we're selling calls that are three or even higher out of the money.

9:29And the options that we sell, Michael, are about just over a month in duration. But one of the historical challenges we call overriding strategies is you sell an option on July 1st, and then a week later, the market's up. Now, what do you do? Do you buy that option back, lock in a loss? Do you tell your investors there's no more upside for the next three weeks? Neither one of those are good outcomes. So what we do, we ladder and stag our options, doing 20 % of our options each and every week. That way there's always more upside to be had by our investors. We're never, ever capped out. Also, if volatility is a little bit higher next week, I get to take advantage of it.

10:05If it's lower, then it's a little bit of a headwind. But either way, this idea of laddering and staggering, as well as always selling options out of the money. And when options are out of the money, the idea here is we're going to give you some of the upside, some of the income. Too often, people just focus on just the income. For us, it's about total return as well. So 2022 was good for, I don't want to assume anything. I assume stock selection, we'll get to that. But it was a good year for selling calls because there was volatility. 2023 is a much different environment. Even with this recent sell-off, the VIX is, I don't know where it is today, 18 or so.

10:38It's still relatively low. So you have a systematic way of taking advantage of upside in call premium should it materialize. But it's not like discretionary where you're going to wake up on Tuesday at 9.45 and say, you wake up at 9.45, but where you'll say, okay, now is the time. Now is the time to sell it. It's more systematic than that. Absolutely. It's a very disciplined approach because the fact is you just don't know what the next move in the market's going to be. You may feel as though the market only is upside. Speak for yourself. I actually have a magic eight ball in my office if you want to borrow it, Michael.

11:10But the fact is, is that you don't know. So if you have a very disciplined approach, it makes the strategy more predictable. As soon as you actually add that layer of unknown, strategies go from very investable to uninvestable. We think our discipline approach makes people be able to understand what to expect, why we'll outperform in certain environments, why we may underperform in certain environments. I think that expectations is good for people who aren't as familiar with the strategy. So I actually have a really good question here from one of our listeners, and I think this will kind of help set those expectations.

11:42So they say they have a decent-sized investment into JEPI, and they said it's been remarkable how little volatility JEPI has seen relative to the broader market while earning a pretty fat yield. The only downsides I can detect so far is that it will get outperformed by the S &P if and when we are in a bull market. This was written in 2022, obviously. And the taxes on the yield are pretty nasty relative to regular dividends. I can handle both of those downsides for the money I have invested. That said, it feels a little rosy. What am I missing? What are your thoughts? So they're kind of asking, what are the tradeoffs for a strategy like this?

12:11And my thought would be that, yes, in a raging bull market, you're going to underperform. In a bear market, you're going to do a little better. So it's a less volatile strategy. So maybe you could make some comments there based on this question. So, Ben, I'm really happy you brought volatility because one of the nice benefits you get of selling calls is not just the yield. You also have it reduces volatility in beta. So a strategy like this is not expected to outperform the S &P 500 in upmarket. How could it with 35 % less volatility in beta than the market without leverage? Because I don't believe in leverage.

12:44So there's no leverage in my strategy. So that's the first thing. The second thing is the taxes. I'm not allowed to give tax advice, so there's my disclaimer. But when you think about it, our dividends in our long portfolio are going to be around 2%. And then the rest is going to be considered a coupon, very similar to any other fixed income product. I'm not sure if I'd call it nasty or rather what every other income-oriented product pays out. It's taxable. Except for munis. It's taxable. Exactly. Exactly. Now, funny enough, when during COVID, I was on a client call at home and the client said to me, so this would be better than a qualified account.

13:20And I said, everything's better than a qualified account. And my daughter, who was 20 at the time, now she's 21 or 22, comes up to me and says, dad, it's like Frank's Red Hot. Put that stuff on everything. And so when it comes to taxes, we want to make sure that we are as tax efficient as we can be. We've never had a cap gain distribution. We don't anticipate having one, but we can't promise anything. But as far as other things that you brought up, Ben, here's what I would say. There's three things that can happen with the market. Up a lot, down a lot, or flat-ish. Up a little, down a little flat.

13:54In an up market, we're not going to keep up. We can't. But even in a year like 2021, we're up 21 and change, with the market up 28 and change. Not so bad with 35 % of this volatility in beta. The market's down a lot. That more conservative, higher quality portfolio plus our options premium helps us eat less of the downside. But going back to the question from one of your listeners, what would be some other challenging environments for the strategy? Number one, the VIX. Michael talked about it before. If the VIX is below 10 like it was in 2017, the income is going to be lower. Long term, we expect seven to nine.

14:31But if the VIX is below 10 like it was in 2017 for 50 of the 250 days, we're going to to be below that long-term average of seven to nine. Another challenging environment would be, what if it's a very narrow-based rally? Well, if it's a very narrow-based rally, we're going to be much more of a broad, long portfolio, capping every name at 2%. Creating that more diversified portfolio for many clients is a welcomed addition. Why? Because they have highly concentrated positions in their growth or their core portfolios. We give them a greater diversification because we cap every name at 2%. And then lastly, when it comes to life, I'm a glass half full person.

15:08No getting around it. When it comes to investing, I'm absolutely glass half empty. What could go wrong, not what could go right. So we want to make sure that if and when the market goes down, that long portfolio hangs in a little better. So that higher quality portfolio, we cap every sector at 17.5%. So we're going to be structurally underway tech in that portfolio. And we could talk about Jeff Q at another time, if you really want tech, how you can combine it with that. But so if tech does all the heavy lifting of the market, the long portfolio could struggle a little bit. If it's a narrow-based rally, the long portfolio could struggle a little bit, but the income is still going to be pretty darn good.

15:44And then lastly, if vol goes really, really, really low, the income is going to be a little bit lower than that long-term average of 7 to 9. Hamilton, one of the things that is evident in studying the market is that investors are risk averse. I think most investors have this mantra, even if they don't define it, they don't know it, they don't spell it out. It's in the back of their head, which is this. I'd rather be out and wish I was in than in and wish I was out. People are risk averse. And so I think that is part of what is so attractive about the strategy is it allows you to be in. And if things go bad, it's not that you're going to avoid the downside, but it's going to be a little bit less or depending on how It'll be less bad than the overall market.

16:31Generally speaking, no guarantees, of course, depending on how stock selection works. So where I'm going with that is a long-winded way of saying, you launched this in 2020, and it went from zero to 28 and changed billion three and a half years later. For something that is not purely passive, it's not passive at all, that's not an index-based product, that's impressive. So what, I guess I just described it, but in your estimation, what is it about this product that has really resonated with the market? I think the explainability. You don't need to get all the upside, but if you know that you're getting that income today.

17:12The second thing is I'm from the Northeast. I grew up in Connecticut. I still live in Connecticut. Income never goes out of style, like LL Bean Boots. It just does knock us out. Income always fits into people's portfolios. And then if you create that positive asymmetry, a little bit more of the upside relative to the downside, Michael, I think that actually also resonates. But one of the things that we've learned in my nearly 14 years of working at J.P. Morgan is if you work with advisors and portfolio managers and CIOs and you help them understand not what you do, but rather how to use a strategy, it actually truly resonates.

17:51I think we've done a pretty good job of helping people understand how to use the strategy. The best analogy I'd give you is if I start talking to you about how people make the sausage, you may actually be forever afraid of eating it. But if I help you think about how to use it on an egg sandwich, in a sauce, on a pizza, in a stromboli, whatever, you're much more likely to find a way to use it. So I think we've done a pretty good job helping investors understand how to use it. It's something that goes back as long as time as far as income and portfolios. On the income side of things, I totally agree with you that that's something that will always just resonate.

18:27And especially since we have this 70 million plus baby boomers retiring, some of them are already retired, some of them are going to be retiring in the years ahead. That income and less volatility is going to be way more attractive. How often is the income paid out of this strategy? Because I'm sure people see that yield and they go, oh, my gosh, that's great. I could live off something like that. How often is that income distributed to investors? We pay it out monthly. And every month, net of fees, we pay out 100 % of our dividends and 100 % of our options premium. Now, some people have asked us, Ben, why don't you bank some, save some for a rainy day?

19:01We don't believe in that. And the reason we don't believe in that is because if markets are more volatile and income is elevated, you've earned that with me because you've navigated this market, which is more volatile. And your child's got a little bit above average income. So we actually just pay out 100 % net of fees each and every month, Ben. Let's talk about the portfolio. What's behind the construction in terms of stock selection? Sure. So I'm very blessed to work at JP Warren Asset Management, where we have a core fundamental research team, over 21 analysts with over 20 years of experience.

19:34And what we do is a traditional, you know, discounted cash flow process, bottoms up, not looking macro, just bottoms up, looking out to the medium to long term as far as stocks that we find fundamentally attractive. However, once we actually find those stocks we find fundamentally attractive, we look even deeper. We're looking for those stocks that have less price volatility and less earnings variability. Why? As I highlighted before, it's not what can go right, but what can go wrong. When markets go down, these higher quality, more predictable earners tend to hang in better. I know I'm dating myself, but they're blue chip names.

20:11Those are the type of names you want to own. In addition, the strategy is called equity premium income. So you would naturally think that we are naturally gravitated to dividends. We're not. Dividends do not come into the investment process. Over 10 % of the portfolio does not pay a dividend. Why? We want to own Google. We want to own Berkshire. We want to own great quality companies, regardless if they pay a dividend or not. And therefore, those stocks, I wish I could say always, but don't always, but usually go down less than the market when the market goes down. So that's why we choose this group of stocks, to have these higher quality names that tend to hang in better when the market goes down.

20:52How often are the stocks changing the portfolio and what's the turnover look like? So the turnover of the portfolio is about 40 % on the stock portfolio. It's about half name changes, just new names coming in and old names going out. And then the other half is much more a stock is down and we're adding a little bit to it or a stock is up and we're peeling a little bit back. But I would say every single day, when you think about forecasting future expected earnings and cash flows, your analysis of those stocks change. But because you're looking to the medium to long term, it doesn't just switch because the stock is up or down 2%.

21:29It's a longer term time horizon, which we're doing this analysis. Hamilton, you mentioned one of the risks to the strategy is a narrow market, which would be a risk to any strategy, right, for the most part. So that's the environment that we're in this year. It's Friday, August 18th. The S &P 500 is up 15%. We don't have to spend too much time on the Magnificent 7. Everybody knows the story there. And so the S &P is up 15. Jeppi's, I'm looking at total return, Jeppi's up five. But if you compare it to, let's say, RRSP, which is the equal weight, it tracks. It's basically, let's see, it's the same thing, 5.1 versus 5.1 versus 5.1.

22:08But if you look at the price variability, this has had a much, much smoother ride than an equal weighted portfolio. This is part of the thing that attracts people to a strategy like this. Absolutely. I mean, when you sell an option, you get all the credit for the income. You never get any credit for lowering volatility in beta. But to me, that's equally important, Michael, because that smoother ride helps folks stay invested. Now, given where we are today, to your point on the narrow-based rally, the fabulous seven or the magnificent seven, I mean, what if the other 490 names begin to wake up?

22:43What if the higher quality names that have been basically unloved this year, but were very loved last year, begin to grow into their 2024 numbers. This strategy could do quite well in that environment. Or if we just muddle on through to year end, because if I was on this podcast December 31st of last year, and I'd say, as you just said, on August 18th, markets up 15%, we would take it and say, done, especially with all the strategists on CNBC and Fox Business and Bloomberg TV trying to scare the heck out of all of our clients. So if we're bringing both sides together of the stock picking and the covered call, a good way to describe this strategy would be the stock selection is lower volatility names, higher quality names, and then with a covered call overlay.

23:34That's kind of the whole strategy if someone wanted to understand this in a 30-second elevator pitch? Absolutely. And the covered calls reduce beta, never takes our stocks away from us. The covered call actually generates some income, which is part of your total return. Because I'm glad Michael just said, let me look at the total return of the strategy. Because with the income, absolutely is part of your total return. Just because I'm giving it to you does not mean I don't get credit for it. I'd like to get a little bit of credit for it. And therefore, this strategy does give you that multi-prong approach to total return.