JEPI vs JEPQ. Both funds are insanely popular among investors. But, why? Under what circumstances is one better than the other? Are there any hidden risks when investing in JEPI vs JEPQ? Let’s tackle these questions in this post.

What are Derivative Income Funds?

Both JEPI and JEPQ are so-called derivative income funds or covered calls ETFs. Meaning, they do invest in stocks, but they also sell call options to generate high yield.

Let’s unpack that. Suppose that you own 100 shares of Apple stock. For some reason, you turn bearish on Apple short-term, but don’t want to sell your position. What many investors do is sell a call option on Apple. A call option gives you the right to buy 100 shares of Apple at a certain strike price in a certain time. For instance, a call option with a strike price of $225 expiring on October 18 trades at $9.20. Call options are given in 100 shares. So, if you buy this call option, you pay $920 and benefit if Apple’s stock price rises above $225 + $9.20 = $234.20. If not, you can lose money.

Conversely, you can sell this call option or go short in other words. In that case, your investment account gets credited for $920. In case Apple stock languishes around $225 or below on October 18, you get to keep this premium of $920. Conversely, if Apple stock price explodes above $234.20, not only an investor loses his premium of $920, but he is also liable for and in red for anything above $234.20.

And, that’s how covered call funds like JEPI vs JEPQ are able to generate large amounts of income in addition to capital gains from their stock portfolios. It is almost all in the form of call option premiums that they sell each week. JEPI has a yield of 7.20%, while JEPQ has 9.16%.

The drawback of covered call funds is clear though. If stock prices of underlying assets shoot up, these funds can lose money. That’s why you see JEPI and JEPQ typically trail their benchmarks by a wide margin in trending bull markets.

At the same time, if underlying assets decline, the covered call option premiums can protect investors from downside, but up to a limit. At some point, if the drawdown is large enough and exceeds covered call protection, JEPI and JEPQ can also decline. So, this is something to keep in mind.

Income from Equity-Linked Notes (ELNs)

Besides holding stocks, both JEPI and JEPQ write (sell) call options. But, instead of doing it directly, they do so through the so-called equity linked notes or ELNs. ELN is a structured investment product that writes call options and distributes any income. So, JEPI uses ELNs to sell one-month call options on S&P 500, while JEPQ sells one-month call options on Nasdaq 100. Both JEPI and JEPQ can invest up to 20% of their assets in ELNs. But, keep in mind that investing in call options is like using leverage. So, even 20% can be big enough to overpower gains from their stock portfolios.

Issues with ELNs

Also, there are a few issues that arise with ELNs. First, they involve counterparty risk. JEPI and JEPQ buy these structured products from other large financial institutions. There is some risk that they may fail at times of stress and not hold their part of the bargain. This could be devastating for JEPI/JEPQ’s performance. The good news is that these funds transact with large global firms via competitive auctions.

The other issue with ELNs has to do with how their income is taxed. As you may know there are many other covered call funds with large yields. Many of them sell call options directly instead of buying ELNs. Typically, income from selling call options is classified as capital gain and does not go into the so-called SEC yield calculations for the fund. For instance, there is a fund called Global X S&P 500 Covered Call ETF (XYLD). Its SEC yield stands at 0.80% because this type of yield counts only dividend and interest income. Of course, XYLD has massive distributions that count as capital gain with a trailing yield of around 11% when counting capital gains distributions.

With ELNs, it is different. Income you receive from JEPI/JEPQ is interest income and taxed at regular income tax rates. That’s why when you look at the SEC and 12-month yield for JEPI vs JEPQ, you see close enough numbers. Nevertheless, if you are planning on holding JEPI or JEPQ in a taxable account, this could be a very bad idea. It is especially true if you are a high tax bracket individual. Conversely, if you fall under the low tax bracket, the issue is less severe, but it is still there.

Comparison of JEPI vs JEPQ

Now, let’s compare these two funds further.

Both funds are by JPMorgan and are actively managed. This means that there is some discretion when it comes to selecting stocks. JEPI’s goal is to construct a defensive portfolio to achieve returns similar to S&P 500, but at a lower volatility. The fund uses JPMorgan’s proprietary data to buy stocks that will decline less in bear markets.

Conversely, JEPQ loosely tracks the performance of the Nasdaq-100 index. JEPQ can at times hold stocks outside of Nasdaq 100. But, their weighting limit is 20% of its assets. 

You probably know that Nasdaq 100 has been outperforming S&P 500 for the past decade or so. Add to this the AI rally of the past year and it is not surprising that JEPQ outperformed JEPI. But, we will come back to returns comparisons shortly.

When comparing expense ratios for JEPI vs JEPQ, they are the same at 0.35%. While this percent is high compared to plain vanilla S&P 500 ETFs, you get a lot of income in return. Both funds engage in somewhat complex strategies, which can justify their higher fees.

Why JEPI’s Yield is Lower?

Now, let’s quickly understand why JEPI’s yield is lower than that of JEPQ. It all comes down to volatility of the underlying indices that these funds short with covered call options.

Paradoxically, call options tend to grow in value when volatility of a stock goes up. The intuitive explanation is that with higher fluctuations, there is a higher chance that the price of the underlying asset can land in the right territory. Historically speaking, Nasdaq-100 has been much more volatile compared to S&P 500. This alone produces higher covered call income for JEPQ compared to JEPI. Hence, JEPQ has a somewhat higher yield too.

But, if volatility subsides for either or both funds, their yields may go down. Counterintuitively, investors in JEPQ/JEPI should embrace and love volatility. This is because it produces higher yields for them.

Another factor behind high yields for JEPI vs JEPQ has to do with interest rates. Call options values tend to grow as interest rates go up, keeping other things constant. It could be that the recent high rate episode is coming to an end and JEPI/JPEQ yields may subside too.

Portfolio Composition Comparison

When it comes to portfolio composition, here is what we see. These funds have an overlap of about 26%, which is low. Unsurprisingly, JEPQ is heavily tilted towards the tech sector. Conversely, JEPI has much more even allocations to various sectors.

In fact, JEPI has a mandate where no single sector can account for more than 17.5%. JEPQ has none of that. So, if sector diversification is important to you, JEPI could be a better option.

As for the individual stock positions, the magnificent 7 dominate JEPQ’s portfolio. The fund is top heavy at almost 43% with some stocks scoring 7% allocation.

As we will see shortly, such high concentration caused JEPQ to outperform JEPI recently. As for JEPI, the fund is required to invest less than 1.5% of its assets in a single stock.

JEPI vs JEPQ: Total Returns Comparison

Finally, here is a comparison of total returns.

Unfortunately, there is barely anything to compare since JEPQ came to life in 2022, while JEPI in 2020. We see that JEPQ had massive outperformance. That is unsurprising with the AI rally. But, in the recent month, things turned sour and AI rally stalled. This is where JEPI shined.

Another observation from here is that covered call funds tend to underperform benchmarks in bull markets. We clearly see that from outsized returns of S&P 500 and Nasdaq-100 compared to JEPI and JEPQ. So, yes, high yields may be enticing. Still, it is always a good idea to check and compare total returns.

JEPI vs JEPQ Verdict: Which One is Best?

Here, we reached that part where I should conclude and say which fund is best. The thing is that there is no definite answer as it depends on individual preferences. Instead, let’s see under what scenarios one could be better than the other.

JEPI is most suitable for someone who desires high yield, but wants to hold a more stable portfolio of defensive stocks. Conversely, JEPQ has a higher yield, but at a cost of higher drawdowns and volatility down the road. True, JEPQ shined over the past 2 years compared to JEPI. But, its outperformance is dependent on where “big tech” stocks are heading from here. If you think they will continue outperforming defensive portfolios like that of JEPI then JEPQ could be a better option.

Also, both JEPI and JEPQ are most suitable for tax-deferred accounts. Otherwise, you will be paying regular income taxes that you can avoid.

Finally, covered calls funds shine in sideways volatile markets, as they capitalize on their covered calls strategies. But, with bear markets, they may provide some downside protection, but not a whole lot. Also, bull markets are real killers of these funds’ performance. Investing in ETFs tracking Nasdaq-100 or S&P 500 would be much superior. This is especially true if you don’t need income now and can wait at least 10 or more years. But, for retirees, JEPI and JEPQ funds represent a real boon with their high yields.