How to ride the highs of US mega-caps (with fewer of the crushing lows)

The popularity of exchange-traded funds (ETFs) with Australian investors continues to rise. And while the passive cohort dominates in terms of product numbers, their active counterpart, exchange-traded managed funds (ETMFs), are on the rise.

At the same time, the “Magnificent Seven” has carried the S&P 500 to record highs as the artificial intelligence mega-theme rolls on. Investors are clamouring to invest in the US mega-caps, defying their inherent concentration risk. For example, these companies comprise some 30% of the S&P 500 index’s total market capitalisation. And in the tech-dominated NASDAQ 100 index, they contributed more than 40% of last year’s total return.

For investors seeking exposure to this growth, while also paying attention to risk, there are vehicles such as the JPMorgan US 100Q Equity Premium Income Active ETF (ASX: JPEQ). J.P. Morgan portfolio manager Hamilton Reiner recently joined us to explain how it works, in the context of his team’s view on where markets are headed from here.

How does the rally of US mega-cap tech stocks in the back-end of 2023 and early 2024 inform your view about where markets currently sit within the economic cycle – and what’s your outlook for the coming 12 to 24 months?

Last year proved we don’t ever fully know what markets will have in store for us, as recession fears turned to soft landing optimism, and markets were resilient on their march to high double-digit returns. It’s also a reminder to investors of why it is important to stick to your strategic allocation and remain invested in equities – even when cash looks compelling!

While we saw spikes in volatility throughout the year, volatility was relatively subdued during 2023. 

For 2024, we are expecting an increase in volatility as the path of inflation, interest rates, as well as the upcoming US Presidential elections could be a driver of uncertainty.

From a fundamental perspective, our equity analysts are expecting 11.5% earnings growth in 2024, with nearly half of that contribution coming from the Magnificent 7.

What are the most important metrics you watch as a gauge of the macro environment – and what are they telling you currently?

We don’t take a macro or top-down approach when managing this strategy. That said, our base case for 2024 is for the economy to continue to expand, although at a slower pace compared to last year. 

We also expect the job market to continue to support the US consumer, currently benefitting from low unemployment and real wage growth. 

Inflation has fallen to more manageable levels, although the path to 2% is not a straight one.

How are the above views reflected in your portfolio, and does this environment increase your emphasis on some of the risk-management features?

With JPMorgan US 100Q Equity Premium Income Active ETF, we seek to provide a balance between income and total return, with less volatility and beta than the index. For investors who like more growth, more tech-focused names, this strategy can provide that exposure more conservatively, along with a steady stream of monthly income.

This means investors are still able to take advantage of exposure to growth/tech stocks but with a lower beta and volatility – essentially, maintaining a more conservative tech-oriented growth allocation with the added benefit of monthly income.

Your stated objective is to invest in the NASDAQ-100 while delivering lower volatility – which parts of your investment process/product design enable you to do that?

We do this by constructing an active Nasdaq 100 equity portfolio leveraging our proprietary data-science-driven investment approach, which seeks to drive portfolio allocations while maximising risk-adjusted expected returns. This underlying portfolio aims to generate positive alpha on top of the Nasdaq 100 Index, while maintaining a relatively low tracking error of around 2% to 3%.

On top of the equity portfolio, we implement an options-overlay strategy. This consists of selling one-month, out-of-the-money call options on the Nasdaq 100 Index to generate income.

The combination of these two building blocks gives you a product that seeks to participate in a portion of the Nasdaq 100 Index upside with reduced volatility, while generating income consistently: something rarely found in growth-biased portfolios.

How do the derivatives components of this strategy work – what are the main advantages of this approach (and perhaps some of the challenges)?

Our options-overlay strategy uses Equity Linked Notes (ELNs). ELNs act as a delivery mechanism for our options premium, allowing the options premium to be treated as a coupon rather than a potential capital gain or return of principal. This ensures our distribution of income every month, without the return of capital.

Our ELNs are highly liquid fixed-income securities, which provide market index and short call option exposure. As with all fixed-income securities, they carry counterparty risk; we have multiple steps in place to diversify issuer risk and transact only with global financial institutions that pass a rigorous risk monitoring process. Additionally, we limit the ELN usage to 20% of the portfolio and 5% with any one issuer.

In what sort of economic or market environment is this product typically expected to deliver the strongest returns? And when might it be more challenged?

There are three main market environments to highlight:

1. Falling markets – we expect this product to do better than equity as the income generated from the options overlay acts as a buffer on the downside;
2. Sideways or gently rising markets – the strategy can participate in most of the upside and generate income at the same time;
3. Rising markets – this is where we are likely to forgo some upside in exchange for income.

As we enter a potentially more volatile market environment, JPEQ can be an attractive way to provide a more conservative exposure to higher-growth companies. At the same time, this investment can also generate income, with the added benefit that higher volatility can result in higher levels of income generation, as options become more valuable as volatility increases.

ETF

JPMorgan US 100Q Equity Premium Income Active ETF (JPEQ)

Global Shares

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ETF

JPMorgan US 100Q Equity Premium Income Active ETF (Hedged) (JPHQ)

Global Shares

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Exposure to Nasdaq 100, with consistent income but lower volatility

The JPMorgan US 100Q Equity Premium Income Active ETF (JPEQ) provides exposure to the Nasdaq 100, with consistent income but at lower volatility than the benchmark. It acts as an income diversifier, distributing income without exposure to duration or credit risk relative to other income-yielding products.

Learn more about JPEQ by visiting the website here.