I’m currently working on a low volatility portfolio for use in a high yield portfolio. I’m planning on designing something that I feel comfortable using with a reasonable margin.
JPMorgan Nasdaq Stock Premium Income ETFs (Nasdaq: JEPQ) has been on my list of research goals for a while. It has a reputation for generating high yields while still maintaining a rough imitation on the basis of the total return of its underlying assets. Few high-yield ETFs can pull this off, and I currently rate JEPQ a Buy.
JEPQ seeks to generate revenue through a strategy centered around selling options on large U.S. growth stocks. It attempts to provide returns comparable to the Nasdaq 100, but with less volatility. They employ proprietary data-driven strategies designed to maximize risk-adjusted expected returns.The fund has started trading Effective May 2022, the current fee rate is 0.35%.
Currently, JEPQ’s largest holdings are Apple (AAPL), Microsoft (MSFT), Alphabet (GOOG), Amazon (AMZN) and NVIDIA (NVDA). The fund also has exposure to the Nasdaq 100 through equity-linked notes.
When looking at JEPQ over multiple time frames, it maintains a relatively high correlation with the Nasdaq 100 Index. I should point out that all of these are looking at performance on a total return basis. Also, to represent the Nasdaq 100 Index, we will use the Invesco QQQ ETF (QQQ). Last month, JEPQ fell 0.25 percent, trailing QQQ’s 1.29 percent and 1.04 percent.
In the past 6 months, JEPQ has risen by 22.22%, 7.81% behind QQQ’s 30.03%.
Last year, JEPQ rose by 20.48%, 6.54% behind QQQ’s 27.02%.
By pairing JEPQ with another asset that is highly correlated with QQQ, we can form a low volatility pair. For that, I have two obvious choices: the ProShares UltraPro QQQ ETF (TQQQ) and their UltraPro Short QQQ ETF (SQQQ). Both are triple leveraged ETFs with their own performance and risk profiles.
I recently wrote an article describing how to generate income by shorting two assets to form a low-volatility portfolio. Both leveraged assets experience long-term decay in NAV because they are designed to correlate to the day-to-day performance of their underlying assets. This makes them unable to remain relevant over longer periods of time.
For any asset, when it falls 20% one day, it needs to rise 25% the next day to recover its previous value. The magnitude of this problem is magnified during more violent operations. A drop of 33% would require a rise of 50% to reach the previous value, while a drop of 50% would require a rise of 100%.
An example of value erosion: If QQQ falls 10% one day and then rises 11.1111% the next day, it will effectively return to its original value.
100 x (0.90) x (1.111111) = ~100.00
However, a triple leveraged ETF designed to correlate to it would have a very different picture:
100 x (0.7) x (1.333333) = 93.33331
To recap: The underlying ETF will not experience a major change after the move is complete, but the leveraged ETF will lose about 6.66%.
While this example represents an unusually large two-day decline followed by a recovery, smaller swings occur periodically and compound over time. This is why long-term holding of leveraged ETFs is not recommended. Enough people misunderstood their actions that both the SEC and FINRA issued warnings.
Which to choose?
To achieve a low volatility pair, we can choose to go long SQQQ or short TQQQ. Both funds have a combined expense ratio of 0.98% and are negatively correlated with the same underlying assets. That’s why they copy each other’s performance.
It is worth noting that SQQQ loses close to 100% over longer time frames. However, TQQQ has the potential to rise significantly in excess of 100% over the same period.
Performance in both roles must be considered when deciding which one to choose. By being long SQQQ, one risks decaying their long-term net worth. By shorting TQQQ, one faces the cost of borrowing fees. Due to their long-term behavior, neither hedge is expected to perform well over an extended period of time.
Neither option seems more attractive than the other. I choose to be long SQQQ because I would rather have a steady management fee than worry about skyrocketing borrowing costs. Also, its near-zero long-term behavior is more attractive than shorting the TQQQ, which has the potential to gain more than 100% in long-term behavior.
My minimum variance calculator shows that for every $1,000 long JEPQ I buy, I buy $220.23 of SQQQ for a variance of 0.0512.
If you scroll up to the one-year chart of TQQQ vs. SQQQ, it becomes clear that short positions on TQQQ or long positions on SQQQ are down about 63% from last year. With such a large decay, the size of the hedge would have to be much smaller than JEPQ to be considered viable. With JEPQ at 81.95% and SQQQ at 18.05% with the lowest variance, this hedge loses value quickly enough that I think it’s better to have JEPQ than to use it.
The performance of JEPQ is tied to the performance of the Nasdaq 100 Index. As long as its underlying index also underperforms, it should underperform. The fund is also actively managed, intentionally weighting certain assets higher than the index. This weighting increases the threat of a larger decline during periods when more heavily weighted assets underperform.
Anytime one chooses to form a low-volatility portfolio with a highly correlated asset, there is always a risk that the two assets will get out of sync with each other. The minimum variance calculation may also be incorrect. Also, depending on the assets you choose and how their underlying mechanisms work, they may have different long-term behaviors, thus requiring frequent rebalancing.
With the yield curve having been inverted for months and the Fed still fighting inflation, we could be headed for a deep recession as the job market loosens.
Catalysts that affect the Nasdaq 100 will also affect JEPQ. The Fed is currently keeping interest rates high to fight inflation. If inflation cools and a soft landing materializes, the market may take the rate cut as a bullish signal and start to rally sharply. However, the Fed also has a history of lowering rates in response to unexpected circumstances. So depending on the context of the reason for the rate cut, this could be bullish or bearish.
JEPQ appears to be an attractive revenue stream. The ttm is 11.4%, which isn’t as high as some of the other sources I’ve been looking at. However, JEPQ does not appear to suffer from the long-term NAV erosion experienced by most covered call ETFs.
The fact that I can’t find attractive currency pairs to form low-volatility pairs doesn’t exclude it from my margin portfolio. However, it does mean that I have to use it with a lower weight. I thought I could find 10 attractive couples and weight each couple to 10% of the portfolio. Since each pair has been designed to have minimal variance, the 10 low variance pairs are grouped together to form a very low volatility portfolio.
However, when I researched the Simplify Volatility Premium ETF (SVOL), I found it attractive but couldn’t find an attractive pairing to form a low-volatility pair. JEPQ is also in the same situation. I’d like to include it, but without volatility hedging. At this point, I might have another two or three months to work on high-quality targets, and don’t know how many more I’ll come across. But I would consider including SVOL, JEPQ and any other similar products unless the overall weight is low.