FEPI: High Yield But Poor Upside Capture (NASDAQ:FEPI)

I came across the REX FANG & Innovation Equity Premium Income ETF (NASDAQ:FEPI) while looking for funds with concentrated exposure to Nvidia (NVDA) and the Magnificent 7 stocks. Other broadly followed analysts have called the FEPI a ‘high-yield tech play’, so I decided to take a look at the fund and see if it is worth investing in, for those seeking concentrated exposures to the FANG stocks.

Overall, the FEPI certainly lives up to its yield reputation with a 14.7% trailing 12-month distribution yield. However, it has grossly underperformed on the total returns front due to the setup of its option bets. By narrowly betting on a handful of highly volatile technology stocks, the FEPI is playing a ‘loser’s game’ where any mistake will cause significant losses or lost returns for the fund. I would personally avoid the FEPI ETF.

Fund Overview

The REX FANG & Innovation Equity Premium Income ETF is marketed as combining big tech stock exposure with the potential for enhanced income using derivatives.

FEPI’s stock portfolio tracks the Solactive FANG Innovation Index (“Index”). This index includes the 8 core technology giants: Apple (AAPL), Amazon (AMZN), Meta Platforms (META), Alphabet (GOOGL), Microsoft (MSFT), Netflix (NFLX), Nvidia (NVDA), and Tesla (TSLA), plus 7 rotating technology companies that are the “top traded names” within the technology space at any given time. The stocks in the index are equal-weighted, which reduces the impact of a few mega-cap stocks.

The FEPI ETF achieves its objectives by purchasing and rebalancing the stocks in the index and selling call options (‘covered call’ or ‘buy-write’) on the individual stocks to generate income (Figure 1). FEPI typically writes call options a little out-of-the-money (“OTM”).

FEPI has lofty claims of providing ‘exposure to leading tech firms” while generating “steady enhanced income by selling out of the money call options”.

Portfolio Holdings

Figure 2 shows the current stock portfolio of the FEPI ETF. As noted above, the FEPI ETF owns the big 8 mega-cap technology giants plus Salesforce (CRM), Advanced Micro Devices (AMD), Intel (INTC), Adobe (ADBE), Palo Alto Networks (PANW), Broadcom (AVGO), and Micron Technology (MU).

Furthermore, looking at the fund’s options portfolio, we can see that the FEPI ETF has sold at-the-money (“ATM”) and OTM calls expiring in July (Figure 3). For example, AAPL closed at $209.73 on June 20th and FEPI is short calls with 210 and 230 strikes. Similarly, MSFT closed at $445.81 and the fund is short 450, 460, and 480 calls.

Capped-Upside/Uncapped Downside Is The Main Risk

I have written many articles on this topic, but the main issue I see with FEPI’s covered call strategy is that it underperforms in the long run due to its ‘capped upside / uncapped downside’ nature.

For example, in the past year, the FEPI ETF has only delivered a 7.1% total returns compared to 31.3% for the Invesco QQQ Trust ETF (QQQ) and 26.6% for the S&P 500 Total Return Index (Figure 4). More importantly, the Roundhill Magnificent 7 ETF (MAGS), a concentrated ETF containing only AAPL, AMZN, GOOGL, META, MSFT, NVDA, and TSLA, has returned 49.5%.

So for all of FEPI’s lofty claims of providing exposure to leading tech firms, it was only able to capture ~14-21% (using QQQ and MAGS as the reference) of their upside in the past year!

High-Risk/Low Reward Bets

Furthermore, similar to my criticism of the YieldMax Ultra Option Income Strategy ETF (ULTY), FEPI’s underlying portfolio of stocks all have relatively higher implied volatilities (“IV”) (Figure 5).

While FEPI claims to be “harnessing big tech’s volatility” and selling the richly priced options, a more cynical view is that implied volatility is simply the market’s forecast for the likely movement in a security’s price. A high IV can be interpreted as the market (or market makers) expecting a large price move in the underlying security, perhaps due to an upcoming catalyst like an earnings report or new product introduction. It does not mean the options are ‘expensive’ or ‘cheap’.

For example, CRM, one of FEPI’s holdings, recently plunged by 19% due to a poor earnings report. While we do not know the exact premiums FEPI received from selling CRM upside calls, it could not have been more than a few percent of the notional of the shares held, so CRM’s recent plunge wiped out many months of FEPI’s premium income.

For reference, an ATM call option on CRM is currently trading at $7.93 with the stock closing at $241.80 on June 20th, or 3.3% of notional (Figure 6).

By narrowing the candidates it sells covered calls on to just 15 stocks, the FEPI ETF may be playing a loser’s game.

To understand why, imagine the FEPI ETF’s strategy as placing 15 bets every month, betting that there will be no surprises in its portfolio companies. If it is correct, the FEPI collects a small reward of a few percent per bet. However, like the CRM example above, when there are negative surprises, the FEPI suffers large losses. Alternatively, if there are large positive surprises, like NVDA’s earnings a few weeks ago, the FEPI also forgoes the large upside reward, as it has already sold away the upside.

So individually, each of these covered call trades is similar to a roulette gambler going to the casino and betting on black. Assuming market makers (i.e. the casino) are good at pricing the securities’ risk, then on average, an investor making a lot of these roulette bets in a portfolio will become a net loser over time, since a single ‘surprise’ can either cause significant losses to the portfolio or cause the portfolio to miss out on significant gains.

Consider These Alternatives Instead

Instead of selling covered calls on a narrow basket of single stocks, investors who wish to capture technology upside while receiving enhanced income from covered calls should look for funds that perform the covered call strategy on a broad technology index like the Nasdaq 100. By owning an index and writing calls on the index, investors reduce the idiosyncratic risks from an individual stock like CRM ‘blowing up’.

For example, investors can consider the JPMorgan Nasdaq Equity Premium Income ETF (JEPQ) which sells OTM call options on the Nasdaq 100 Index. Not only is the JEPQ cheaper than FEPI (0.35% fees vs. 0.65%), the JEPQ has provided double the returns of the FEPI ETF in the past year, capturing ~50% of the upside on the QQQ (Figure 7).

The only reason investors may be enamored with the FEPI is because of its distribution yield. The FEPI is paying a 14.7% trailing 12-month distribution yield compared to JEPQ’s more pedestrian 8.8% (Figure 8).

However, I encourage readers to look beyond the headline distribution yield and consider total returns instead when analyzing fund performance.

I last wrote about the JEPQ here.

Risks

While underperformance is the largest risk for the FEPI ETF, there are other risks investors should be aware of. For example, due to the incredible multiple expansion we have seen in the past two years, technology stocks are now extremely ‘expensive’ relative to the market (Figure 9).

While valuation is only one factor in stock performance, it does suggest there could be a lot of downside to these stocks if the market turns sour.

Conclusion

The REX FANG & Innovation Equity Premium Income ETF is marketed as providing technology exposure while paying an attractive distribution yield. While the FEPI has certainly lived up to expectations on the distribution front, with a 14.7% trailing 12-month yield, I find the fund’s upside capture of technology stocks’ total returns to be lacking.

The problem is that the FEPI ETF writes call options on a small basket of highly volatile technology stocks. In exchange for a paltry monthly premium, investors are exposed to significant single security risks, both on the downside and on the upside. Over the long run, this is a ‘loser’s game’ that causes the FEPI to dramatically underperform.

I would personally avoid the FEPI ETF and consider alternatives like the JEPQ that write call options on the broader Nasdaq 100 Index, which reduces idiosyncratic security risks.