FEPI Stock: So Far So Good (NASDAQ:FEPI)

I’ve first written about REX FANG & Innovation Equity Premium Income ETF (NASDAQ:FEPI) a few months ago when the fund was first launched in an article titled FEPI: This New Covered Call Fund Shows Some Potential. Back then, we didn’t know much about the fund except its overall strategy of owning the top 15 technology stocks in the US and writing monthly covered calls on each individual stock to generate income. It’s been a little over 3 months since the fund launched and the results look promising so far.

In its first few months, the fund was able to generate high income coupled with share price appreciation, and its strategy of selling out of money monthly calls on individual tech stocks seems to be working. I expect this fund’s performance to continue moving forward as long as it keeps its strategy intact and the overall market remains at least stable. Remember, the market doesn’t have to rally for this fund to do well, it just needs to be stable since most of the returns come from option sales.

At the time of my previous article, there had been no dividend distributions, and we had no idea what this fund was going to pay, but I had made an estimate that it should yield somewhere between 20% and 30% and so far the fund’s annualized yield for the first 3 months came out at 25% which was at mid-point of my estimate. More interestingly, the fund has been raising its distributions slowly but surely every month, up from $1.15 to $1.18 and then to $1.20 in the last 3 months.

One thing I find impressive in FEPI’s performance so far is that it was able to achieve both high yield and share price appreciation at the same time, while most covered call funds will sacrifice one for the other. Since its inception, FEPI’s share price appreciated by 8.22% in addition to paying about 6% in dividend distributions during this time. In comparison, the most popular covered call funds were up about 2-4% during this time.

FEPI’s total returns since its inception are close to 15% which beat not only most of its peers but even the overall market performance even though the S&P 500 (SPY) had a very strong performance in recent months.

There are a few reasons as to why FEPI has performed so well in recent months. First, it holds and writes covered calls against big tech stocks such as Apple (AAPL), Amazon (AMZN), Microsoft (MSFT), Nvidia (NVDA) and Google (GOOG). We all know that big tech has been carrying the markets for the last year or so with their outstanding performance.

Second, the fund is actively managed, and it writes covered calls that are actually out of money, which allows it to participate in some of the upside. Typically, the fund’s options will be out of money by only about 5-10%, but that’s still plenty of upside for a month considering it sells monthly calls.

Third, it writes calls on individual stocks and not the index, which is a big plus. When you write calls against the index, you will generate about 12-15% annually while IV of the index ranges around 12 to 20 but when you write calls against individual stocks whose IVs range from 20 to 50, you can generate as much as 25-30% per year, which is where my estimation of 20-30% yield came from in my original article which has been in line so far.

Below is the 30-day volatility for the magnificent 7 which make up about 50% of FEPI. I’d like you to notice two things. First, volatility overall has been trending downward throughout the last year. Average volatility is down almost by half since last year, and it especially took a dive in the last few months while the market rallied to new highs. Second, the volatilities of magnificent seven stocks range from 13 to 47 while the S&P 500’s volatility is as low as 10, so these stocks have at least 30% to 400% more volatility as compared to the index which means there is more IV to harvest for option sellers when they sell options on individual stocks as opposed to the index.

Here is the funny thing though. FEPI’s own volatility as a fund sits at 10.09% which is the same as S&P 500’s volatility. What this means is while the fund is harvesting higher volatility of individual big tech stocks, it is not reflecting this high volatility on investors. It is remarkable because investors who are holding this fund are somewhat cushioned against most of the volatility its holdings have.

Currently, the fund holds a variety of covered call positions with a variety of strike prices. For example, for Tesla (TSLA), it sold some calls expiring at $195, $220, $230, $240 and $250 all expiring on February 16th. As of the time of writing this article, TSLA is trading at $190 so all those options are still out of money. If TSLA were to rally from here, the fund would participate in some of the upside, all the way to $250.

The same is true for most of the fund’s holdings. It has layers of covered calls on each of its stock holdings at a variety of strike prices which means it tries to strike a balance between collecting the most premiums and being able to participate in as much upside as possible which is a very difficult task for a covered call funds and unfortunately most covered call funds fail at that.

This fund has only been around for a few months, so it’s still too early to talk about its long-term performance, but results are impressive so far. We don’t know for sure if this performance will continue, but we like what we are seeing, and we like the fund’s overall strategy of holding big tech stocks and writing monthly out-of-money call options in a layered fashion.

In the last 2 months, FEPI marked its distributions as return of capital, which gave them a tax advantage. Many times investors are worried about return of capital distributions, but they are not necessarily a bad thing. They are only a bad thing if you also see a NAV decay. If a fund’s NAV keeps rising while it’s marking its distributions as “return of capital” you should be happy about it because it means your taxes on those distributions will be deferred. How does the fund do it? Well, let’s say you own 100 shares of AAPL and you wrote covered calls against them. You bought shares at $180 and wrote covered calls at $190. Then stock climbs to $200 and you buy those covered calls back. You made a profit on your AAPL shares but made a “loss” on your covered call position. Since you are still holding your AAPL shares, your profit on those shares is unrealized while your “loss” on those calls you sold is realized, which opens the door for ROC and deferred taxes.

If you wanted to hedge against this position, you might be interested in buying QQQ put spreads. This would protect your FEPI positions fairly well because the 15 stocks being held by FEPI account for more than 60% of QQQ’s total weight, so there will be a strong correlation between the two. You could buy QQQ $390 puts expiring in July and sell QQQ $340 puts expiring in the same month, which would cost about $4.92 per contract and offer protecting up to $4,508 per contract if you were inclined to do this. Put spreads are particularly cheap this time of the year because volatility has been super low lately. You can also buy $390 puts for $7.35 which would cost slightly more than buying a spread, but it would offer a much larger protection. For example, if QQQ were to drop to $300, your puts would be worth about $90 a contract or $9,000 per position.

Still, if you don’t want to hedge your position, it’s perfectly fine too. As I always say, the best hedge is to diversify your position. If a position makes no more than 10% of your total account, you won’t have to worry too much about it losing value because it won’t cause your portfolio to take a huge hit. Hedging by using options is good if you want to be super cautious, but you also don’t want to overdo it to a point where your total return is significantly diminished.

Risk Factors

The biggest risk factor for this fund is the fact that tech stocks are currently enjoying very stretched valuations. Since January of 2023, Nasdaq is up 50% mostly driven by mega-cap tech stocks. More specifically, Magnificent Seven stocks are up almost 100% year over year. Many of these stocks now have high valuations where their P/E ratios range from 25 (Google) to 100+ (Nvidia, Amazon, and Tesla). This gives investors a small margin of safety. Since FEPI sells covered calls, if the stock market were to stay flat or decline slowly in an orderly fashion it would be ok, but if we had a sudden market crash or something similar to Nasdaq’s crash in the 2000-2002 period, things might get scary. Some investors may benefit from buying puts or put spreads I mentioned above if they believe those scenarios are likely in the near future.

Looking Forward

Moving forward, I expect tech stocks to be a little more volatile. Since tech stocks are enjoying high valuations, we probably won’t see a repeat of 2023 anytime soon, when Nasdaq climbed 50%. We could still see tech stocks growing at a decent rate or staying flat, but FEPI should be able to outperform the market as long as it doesn’t rise 25% per year. At the very least, it should continue to provide stable income as long as the market doesn’t have some sort of violent crash. Moving beyond one year, tech stocks should continue to have healthy returns in the long term, as they have been enjoying for the last 40 years or so. This is more of a long-term play.

Conclusion

The fund has been around for only a few months, but its performance so far is impressive. If the fund can continue this performance, it should generate healthy levels of income for investors without giving up NAV performance. It’s very rare to find a covered call fund that has a high yield as well as price appreciation, and FEPI has the potential to get there in the long term.