sefa ozel
Recently, I have seen many investment analysts and news outlets discuss the possibility of ‘Volmageddon 2.0’ (Figure 1).
Figure 1 – Option income assets have grown rapidly in recent years (Elliot wave International via X)
According to these analysts and reporters, investors pouring billions into ETFs selling options is betting on calm markets and may ‘blow up’ in a ‘Volmageddon 2.0’ event.
One of the largest ETFs engaged in these ‘short-volatility’ bets is the JPMorgan Nasdaq Equity Premium Income ETF (NASDAQ:JEPQ), with almost $12 billion in assets, or about 20% of the market.
Should investors be concerned about the JEPQ ETF being wiped out?
I believe the risks are overblown for the well-tested buy-write strategy employed by JEPQ. Instead of blow-up risk, investors should be more concerned about overvaluation of the underlying portfolio and ‘capped upside / uncapped downside risks’.
Brief Fund Overview
To answer whether the JEPQ will be wiped out in a ‘Volmageddon 2.0’ scenario, we must first understand the fund’s strategy. The JPMorgan Nasdaq Equity Premium Income ETF is a buy-write ETF focused on the Nasdaq 100 Index (Figure 2).
Figure 2 – JEPQ investment process (am.jpmorgan.com)
The ‘buy-write’ strategy (also known as covered call strategy) employed by the JEPQ ETF is fairly simple and has been used for decades by investors looking to supplement their portfolio’s income in exchange for some portfolio upside. Basically, the JEPQ owns a portfolio of stocks that are similar to the NASDAQ 100 Index. It also writes one month out-of-the-money (“OTM”) call options on the Nasdaq 100 Index to generate income (Figure 3).
Figure 3- Illustrative covered call strategy (investopedia)
According to the fund manager, the JEPQ ETF is expected to deliver returns that consist of the portfolio’s dividends plus 8-10% in premiums from written call options plus market participation of its stock portfolio, less any forgone upside from the options sold (Figure 4).
Figure 4 – Illustrative returns of the JEPQ ETF (am.jpmorgan.com)
Readers interested in learning more about the mechanics of the JEPQ ETF can refer to my initiation article from last August.
Volmageddon Wiped Out Short-Vol Funds
The big fear from market pundits is a replay of the 2018 ‘Volmageddon’ event, when short volatility funds like the VelocityShares Daily Inverse VIX Short Term ETN (“XIV”) were wiped out virtually overnight as the CBOE Volatility Index (“VIX”), a measure of expected market volatility in the S&P 500 Index, jumped by 20 points and doubled.
Short volatility funds like the XIV were betting on calm equity markets persisting and were engaged in shorting near-term VIX futures. When the spot VIX Index doubled, the futures the XIV were short also doubled and the XIV was effectively wiped out, with the asset shrinking from $19 billion to $63 million in one session.
Are We Heading For Volmageddon 2.0?
To the casual observer, Figure 1 may look ominous. If $2 billion in short-vol assets in 2018 caused Volmageddon 1.0, wouldn’t over $60 billion invested in dozens of option income ETFs that short volatility be an even bigger time bomb?
In my opinion, I believe the current fear around ‘Volmageddon 2.0’ may be simply fearmongering and click-baiting. For the most part, the current batch of products is buy-write strategies like the JEPQ and its larger sibling fund, the JPMorgan Equity Premium Income ETF (JEPI) that are long the underlying securities and short call options against them.
For the JEPQ ETF to be wiped out, all the stocks held in its portfolio will have to go to zero overnight. This simply will not happen, due to both fundamental and technical reasons. Fundamentally, while one can argue that the high-flying tech stocks underlying the Nasdaq 100 Index like Nvidia (NVDA) and Apple (AAPL) may be overvalued, they are also some of the largest companies in the world and at some price, investors would snap them up hand over fist. Technically, stock markets now operate with circuit breakers that halt trading if the S&P 500 Index drops 7%, 13%, and 20% in a single session. So investors can rest assured that JEPQ will not be wiped out a la “XIV”.
Capped-Upside/Uncapped Downside Is The Main Risk
The real risk with buy-write strategies is not an epic XIV-style blow-up, but rather, underperforming in the long-run due to its ‘capped upside / uncapped downside’ nature. For example, in the past year, the JEPQ ETF has only delivered a 24.5% return compared to 31.0% return for the Invesco QQQ Trust ETF (QQQ), as the Nasdaq 100 Index has been in an uptrend and JEPQ has traded away some portfolio upside (Figure 5).
Figure 5 – JEPQ has underperformed in the past year (Seeking Alpha)
Furthermore, as we have seen in the past month, when markets decline, selling calls provide little downside protection, as the JEPQ ETF has returned -4.9% vs. -5.5% for the QQQ in the past month (Figure 6).
Figure 6 – While offering little protection during drawdowns (Seeking Alpha)
However, for most income-oriented investors, this trade-off between portfolio upside vs. enhanced income is something they are willing to make.
Conclusion
The JEPQ ETF is a growth-focused ETF using a time-tested buy-write strategy to provide enhanced income from writing call options on the Nasdaq 100 Index.
While the proliferation of option income ETFs may indeed be suppressing market volatility and be a cause for concern, I believe the fears around ‘Volmageddon 2.0’ are overblown for buy-write strategies like the JEPQ. Simply put, it is impossible for JEPQ to suffer an XIV-style wipe out. Instead, investors in JEPQ are at risk of underperforming in the long-run from the ‘capped upside / uncapped downside’ nature of the strategy.
For now, I believe the high-flying stocks within the JEPQ ETF are overvalued, so I would personally avoid the fund. However, I believe the JEPQ ETF may be suitable for long-term income-oriented investors who want to receive high distributions from a growth portfolio. I continue to rate JEPQ a hold.
