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

Today'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. Take her jeppy. 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 shell about markets, life, and investing. Join Michael Batnik 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 Red Holt's wealth management. This podcast is for informational purposes only and should not be relied upon for any investment decisions. Clients of Red Holt's wealth management may maintain positions in the securities discussed in this podcast. The price of equity securities may fluctuate rapidly or unpredictably, due to factors affecting individual companies as well as changes in economic or political conditions. These price movements may result in loss of your investment. Investments in equity link notes are subject to liquidity risk, which may make ELNs difficult to sell and value lack of liquidity. They 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 Annel Spears with Michael and Ben. Michael, we got this email from someone last year, kind of tongue in cheek, but I think that they there was some truth into it. At 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 newly, if a couple of years old, it's a covered call strategy that also invests in low volatility stocks and high quality stocks, and this thing has just been raking in the money. A lot of people really like it for the effect 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. I 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 would you agree with my assessment assessment? 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 that just like having that have been, I'm leaving the principle alone and I'm living off the income or whatever. I think I would disagree with that mindset. Oh, 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 advice 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. We were joined today by Hamilton Reiner. Hamilton is an MDPM and head of US equity derivatives at JPM as a management. Hamilton walked into the show. Thanks for having me guys. Truly appreciate it. We get a lot of questions that are inboxed from people. Sometimes they're broad market base. 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 JPM Organ'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 a stock selection and how the code cover call thing works. Absolutely. So my background is 35 years of investing in equity and equity options. And when I first joined JPM Organ's management, the idea is how can I actually do options in a delivery mechanism that can actually make them more widely used. So with Jepi, our goal was actually to try to find a way to call overriding, but do it in a 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. I 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, they can 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. What are the mechanics behind a covered call? Just basics. How does it work? So traditionally, the way a cover 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 be like you can generate some income short term. But historically, you own an underlying stock or an index and then you sell it 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% and 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. I'm going to be blocking the 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, the traditional call variety 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, meaning 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 seven to nine percent distributed income. And that's doing options on the index. Yes, 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 mouse amount of income. And to be quite frank, no one's ever really complained about 79 percent distributed income. So there's two components of the strategy. There's the income that you that you receive from selling the calls. And then there's the active component. So we'll get to the we'll get to the stock selection. But before we do, 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. How does it work? Are you laying a laddering this out? Is it just you continue to roll? How how does the options selling strategy work? So when I think about the approach you take from 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, right? Oftentimes people sell at the money option for going all the upside. We want to get balanced or portfolio, some upside and some income. The other thing that I think is important is you need to have some type of flexibility based on market environments. So if you always sold and 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 it's about 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, it's called 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 3 or even higher out of the money. And the options that we sell Michael are about just over a month in duration. But one of the historical challenges we call overwing 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 3 weeks? Neither one of those are good outcomes. So what we do, we ladder and stagger 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 all it's a little bit higher next week, I get to take advantage of it. If 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 to focus on just the income. For us, it's about toll return as well. So 2022 was good for, I don't want to assume anything. I assume stock selection will get to that. But it was a good year for selling income for selling calls because there was volatility. 2023 is a much different, as much different environment. Even with this recent sell-off, the VIX is, I don't know where it is today, 18 or so. It's still relatively low. So you have a systematic way of taking advantage of upside in call premiums should 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 is going to be. You may feel as though the market isn't upside. Speak for yourself. I actually have a magic April in my office in one of our Michael. But the fact is, is that you don't know. So if you have a very disciplined approach, it makes a strategy more predictable. As soon as you actually add that layer of unknown strategies go from very investable to uninvestable. We think our disciplined approach makes people be able to understand what to expect, why will outperformance certain reach environments, why we may underperformance 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. So they say they say they have a decent size 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 trade-offs for a strategy like this? And my thought would be that, yes, in a raging bull market, you're going to perform 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 about 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 a bull market. How could it with 35% of volatility in beta in the market without leverage? Because I don't believe in leverage. So there's no leverage in my strategy. So that's the first thing. The second thing is the taxes. I'm not allowed to get tax advice. So there's my disclaimer. But when you think about it, our dividends and our long portfolio are going to be around 2%. And then the rest is going to be considered a coupon. Very similar to like 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. Taxable. Except for muties. It's taxable. 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. And 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's like, brings red hot. Put that stuff on everything. And so when it comes to taxes, you know, we want to make sure that we are as tax fishes. We can be. We've never had a cap game distribution. We don't anticipate having one, but we can't promise anything. But as far as other things that you brought up then, 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. And in up market, we're not going to keep up. We can't. But even in the year like 2021, we're up 21 and changed with the market up 28 and changed. Not so bad with 35% of volatility and 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 7 to 9. But if the VIX is below 10 like it was in 2017 for 50 of the 250 days, we're going to be below that long term average of 7 to 9. Another challenging environment being what if it's a very narrow-based rally? What 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 great diversification because we capped every name at 2%. And then lastly, when it comes to life, I'm a glass half-full person. No getting around it. When it comes to investing, I'm absolutely a 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 capped every sector at 17.5%. So we're going to be structurally underweight tech in that portfolio. And we could talk about JEPQ at another time. If you really want tech, how you can combine it with that. But so if tech does all the heavy lifting in 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. And then lastly, if ball goes really, really, really low, the income is going to be a little bit lower than that long-term average of 79. 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, generally 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 change billion three and a half years later for something that is not purely and 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, the 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 L being boots. It just does not go out of style. 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 that my, you know, nearly 14 years of working in Jake 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. I 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 and a sauce, on a pizza and a strum bowl or 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 and something that goes back as long as time as far as income in portfolios. On the income side of things, I totally agree with you that that's something that will always just resonate. And 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 as 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 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, then why don't you bank some, save some for a rainy day? We 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 earn that with me because you've navigated this market, which is more volatile, and you're talking about a little bit above average income. So we actually just paid 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 J4 and S management where we have a core fundamental research team over 21 analysts with over 20 years of experience. And what we do is a traditional 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 a blue chip name. So those 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. How 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. It's new names coming in and new names 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, you know, 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 upper down 2%. It's a longer term time horizon, which we're doing this analysis. Hamilton, you mentioned one of the rest of the strategy is 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 August, it's Friday, August 18th. The S&P 500 is up 15%. You know, we don't spend too much time on the Magnificent 7. Everybody knows the story there. And so the S&P's up 15, Jeffies, I'm gonna get a total turn. Jeffies up five. But if you compare it to let's say RSP, which is the equal weight, it tracks. It's basically, let's say it's, it's the same thing, 5.1 versus 5.1 versus 5.1. But if you look at the price variability, this has had a much, much smoother ride than an equal weight in 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 and beta. But to me, that's equally important, Michael, because that's smoother ride helps folks stay invested. Now, given what we are today, to your point on the narrow base rally, the fabulous 7 or the Magnificent 7, I mean, what if the other 490 names begin to wake up? What 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, March is up 15%, we would take it and say, done, especially with all the strategies done, 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. That's kind of the whole strategy of someone 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 as 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 the strategy does give you that multi-prong approach to total return. You're going to get some dividends, some options premium, and then some of the upside that three-prong approach to return works quite nicely in most market environments. This is a, it looks like it's a roughly equal way to portfolio. I'm guessing there's like, you know, it's not equal in the sense that they're all the same, but there's drift involved, right? The price go up, price go down, some get bigger, some get smaller. Maybe take a second and just talk about some of the resources that you have at JP Morgan to help you with the stock selection. Absolutely. I told you we have 21 analysts and they're incredible. The first thing I'd say is they're not just analysts. What is the traditional role of an analyst? They knock on your door, Michael, and they say, you know what? I think you should buy stock XYZ. You buy it, it goes up, you guys high five each other. It goes down, they hide from you for months because they don't want to have to face you for buying a stock that went down. Or you don't buy and it goes up and they're like, I told you so. Or something like that. Our analysts actually have real skin in the game. They actually are stock picker, stock selectors. They actually are part of running an analyst fund, a best idea analyst fund. So you see their conviction as to how they put their allocations and their money into their securities. So they're not just analysts who say, I told you so, or you should do this. They're actually putting their money and clients money into their strongest and highest conviction ideas. Number two, one of the nice things that has happened to active managers as passive is grown is it's easier to get time with management, right? If assets used to be 80% active, 20% passive, now that it's 50, 50, I have less people to compete with to get in front of management and talk to them. So when we have that type of approach where we have these analysts that do deep analysis, they each cover between 25 and 35 names. They actually know the CEOs, the CFOs, the COOs. In some cases, some of our analysts have been doing this for 20, 30 or even longer years. Boards talk to them. CEOs talk to them about, I'm thinking about bringing this person into my firm. What do you think? They're really being consultative to many of the firms that they cover. So it's definitely competitive advantage for us, Michael. Hamilton, when it comes to the success of an ETF, some strategies are going to do well, regardless because there's just always going to be demand for them. I agree with you that the income side of this strategy probably would have done well whenever it was released, but it came out. It looks like a little over three years ago, 2022 was a great year for this strategy. There was a Wall Street Journal article that talked about all the money going into cover call strategies. Jepi was one of the funds that was named. If I injected you with true serum, and when this thing was released three years ago, and you looked back at it now, would you be surprised at how big the strategies I think it has almost 30 billion dollars in assets was this expected? How are you feeling personally for the success of the strategy in terms of bringing in assets? Ben, you don't need truth serum. Here's what I'll tell you, anyone who can sit on this podcast for anywhere and said, I would expect a strategy in three and a half years to become the largest active ETF in the industry. And over $28 billion is crazy. Okay, I didn't know it was, so this is the largest active ETF strategy. Okay, maybe I didn't know that. Wow. In the world. Pretty remarkable. And, but what I did feel as though it had enough positive qualities that people would want to put in their portfolios. If we can give people a portfolio that they would like or love, even without the options component. If you then on top of it, can actually lower the volume lower the bait of owning those type of aims. And then on top of that, you could throw off some income every month. We thought we had a chance of being successful. So I really felt as only launched it. It took my 30 plus years investing in equity and equity options and tweaked it to truly try to find a way to eliminate what I would cost some of the traditional headwinds around call of rights strategies. Did I expect it to hit where it is today? No. Did I think it was going to be successful? I did. Hamilton, like we said earlier, this is literally the number one ETF that we've been asked about over the years. So the fact that it's number one in its category is not too big of a surprise. We really appreciate you taking the time and explaining the story to our listeners. So thank you. Thanks for having me. I appreciate it, guys. See you at the future proof. Oh, hell yeah. I didn't know you're going to be there. Fantastic. I'm going to be there. I can't wait. Awesome. We'll see you there. Thanks again to Hamilton and David Morgan. That's a management number. Check our show notes for the links and email us analyst here at the team about time.