QYLD - Defiance QQQY: 60% Yields And Free Lunches

2023-12-11 11:00:46 ET

Summary

• There has been an explosion in assets chasing option income.
• Defiance Nasdaq 100 Enhanced Options Income ETF launched recently and added a twist to this strategy.
• The fund charges a 1% fee and has had a strong start in terms of distributions, but performance has lagged behind plain vanilla ETFs.
• We look at what the fund does and what you can expect.

Option income is a popular tool and one we enjoy deploying. It appears the market agrees with this love and there has been an explosion in assets chasing this. From JPMorgan Equity Premium Income ETF ( JEPI ) to Global X NASDAQ 100 Covered Call ETF ( QYLD ). These two alone have close to $38 billion in assets. That is a mighty accomplishment in an era of passive ETFs all competing on trying to shave off the last two basis points in management fees. In addition, we have more exotic funds like Nationwide Nasdaq-100® Risk-Managed Income ETF ( NUSI ) which use options to dampen volatility. We also have covered call Closed End Funds which give yet another flavor to yield chase. So it was bound to happen that someone thought of this concept, that we see with Defiance Nasdaq 100 Enhanced Options Income ETF ( QQQY ).

The Fund

QQQY modeling the name off perhaps the Nuveen NASDAQ 100 Dynamic Overwrite Fund ( QQQX ), (which is yet another covered call fund) just launched on September 13, 2023. The fund aims to generate a hefty income using put options. While most funds have been focused on call writing, anyone knowing the put-call parity theorem would understand that you can make good money on both sides of the aisle. The fund invests its money in cash equivalents like Treasuries and then gets to work selling puts. The holdings shown below are actually all that the fund owns.

The twist here is that the fund is focusing on selling very near term puts where your theta decay is off the charts. It also will combine this with an at-the-money or in-the-money for the strikes.

Every day, the Fund will sell put options that are priced either at-the-money or up to five percent in-the-money (i.e., higher than the current market price). If the Fund sells an option that's priced above the current market price, the Fund may profit if the Index increases in value above its current price. This opportunity exists until the option's expiration date, which is typically the next day. This happens because an option priced above the current market value has a higher premium than an option priced at the current market value. In other words, the Fund's potential for profit (or exposure) fluctuates. This potential for profit is calculated daily over a certain time period, but it's also balanced out by any losses that might occur during that same period.

Source: QQQY

For this unusual setup, the fund charges you the standard price of entry which comes to about 1%.

Distributions & Performance

The fund has been off to a banging start, especially as far as the distributions are concerned. The fund launched at $20.00 and is on schedule to distribute at a 60% annualized rate.

Funnily, that same screenshot shows the 30-day SEC yield at 3.41%. So which is it? Are we making 60% or 3.41%? Well on a raw price basis, you can see QQQY is down 12.24% since inception and that inception was less than one quarter back as we write this. Total return was a more respectable 3.52%, but that amount still lags what the plain vanilla Invesco QQQ Trust ETF ( QQQ ) (which does no options), shows.

How exactly this is working out is anyone's guess, but the massive NAV depletion almost matching the distributions shows that you cannot generate total returns beyond what the index is doing.

Outlook

Selling maximum levels of theta with zero-day or 1-day options is about as far away as one can get from what we consider a sound strategy. There are a few reasons for this. The first is that while theta decay is high, absolute premiums are low relative to the index or stock. In other words, options provide little downside protection from a steep market downturn. We have been hyper-critical of this modality of option selling even at the weekly level, so it stands to reason that we won't be sparing any jabs when they go to daily timelines. The second reason here is that the underlying is the NASDAQ. Powered by the "Magnificent 7" and running at valuations that defy sanity. So we are trying to make option income in the last gasps of the bubble based on the seventeenth attempt to correctly forecast interest rate cuts. The added twist here is that we are not even remotely trying to generate total returns that come in the ballpark of the option income. The final reason here is that Vega is really low.

So you are taking maximum risk here at every level. As the NAV depletes, the "yield" may still be high but will decrease on your original cost.

Verdict

This fund will appeal to those that enjoy getting high income while watching (or rather not watching) the capital deteriorate. So investors in Icahn Enterprises L.P. ( IEP ) getting 25% "yield" are likely to be heavily enticed to buy this. Another group of investors who might like this are those that hang in these high income payouts for years in the hopes they actually reach a zero-cost basis and then can play with "house money". They will enjoy this one as well.

Finally, there are those that stopped reading when they saw the 60% distribution yield and bought this the moment the markets opened. All while singing " Baby, I Got Options, I Got Options, But I Only Want You ".

For the rest, who enjoy focusing on capital preservation and total returns, this should be a hard pass. The only free lunch here is that you have our warning that your real returns will be dictated by how long the AI bubble stays inflated. For those that want option income without doing our methodical process , JEPI offers the best choice. We had recently actually suggested investors can even buy QQQX as it does a relatively decent job in this arena, and it had a massive discount to NAV. That would be one to watch in a brutal selloff to pick up again. But we would not touch a fund trying to sell in-the-money put options on the NASDAQ 100.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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