QYLG - QQQX: Discount To NAV Presents A Buying Opportunity
2024-01-02 14:40:38 ET
Summary
- QQQX fund has historically underperformed compared to mechanical overwrite funds like QYLG.
- However, the QQQX fund is currently trading at a historically wide 7% discount to net asset value.
- Despite NAV underperformance, the discount to NAV presents a buying opportunity for income-oriented investors, assuming this discount will close in the coming months.
A few months ago, I wrote a cautious article on the Nuveen NASDAQ 100 Dynamic Overwrite Fund ( QQQX ), arguing the 'dynamic overwriting' strategy of the QQQX fund appears to add 'negative alpha' compared to mechanical overwrite funds like the Global X Nasdaq 100 Covered Call & Growth ETF ( QYLG ). Although both QQQX and QYLG overwrite approximately 50% of their portfolios, the QQQX fund had historically underperformed QYLG.
Since my article, the QQQX fund has delivered -2.5% in total return, which seems to justify my caution (Figure 1).
Figure 1 - QQQX has delivered negative total returns since July (Seeking Alpha)
However, investors appear to have heeded my advice too well, punishing the QQQX fund to a historically wide 7% discount to net asset value ("NAV") (Figure 2).
Figure 2 - QQQX is trading at a historically wide discount to NAV (cefconnect.com)
In fact, if we look at QQQX's NAV returns for 2023, the QQQX fund actually performed well, returning 35.1%, significantly ahead of the fund's market price returns of 21.9% (Figure 3).
Figure 3 - QQQX's market price return has lagged its NAV returns in 2023 (morningstar.com)
The unwarranted sell-off in QQQX units now presents an interesting opportunity for investors, as the QQQX fund's discount to NAV is near the widest in the past 5 years.
Brief Fund Overview
First, for those unfamiliar with the QQQX fund, the Nuveen Nasdaq 100 Dynamic Overwrite Fund is a closed-end fund ("CEF") that holds an equity portfolio that substantially replicates the Nasdaq 100 Index while dynamically selling call options ("call-overwrite") on 35-75% (long-term target of 55%) of the portfolio's notional value to generate income.
This theoretically allows investors in the QQQX fund to capture some of the upside from the Nasdaq 100 Index while supplementing the Nasdaq 100's meager dividends with call premium income.
The QQQX fund has been popular with investors, garnering $1.1 billion in assets while charging a fat 0.91% total expense ratio (Figure 4).
Figure 4 - QQQX capital structure and fees (nuveen.com)
QQQX's equity portfolio essentially replicates the Nasdaq 100 Index, with major holdings in technology heavyweights like Apple Inc. ( AAPL ) and Microsoft Corporation ( MSFT ) (Figure 5).
Figure 5 - QQQX top 10 holdings essentially replicates the Nasdaq 100 Index (nuveen.com)
The key 'active return' component of the QQQX fund lies in its 'dynamic overwriting' strategy. As of November 30, 2023, the QQQX fund had overwritten 52% of the portfolio with average call strikes being 97% of spot price (i.e., in-the-money calls) (Figure 6).
Figure 6 - QQQX overwriting 52% of its portfolio (nuveen.com)
QQQX Still Underperforms QYLG…
In my prior article, I made the claim that QQQX's 'dynamic overwriting' strategy appears to underperform the mechanical overwriting strategy of the QYLG ETF. In contrast to QQQX, QYLG mechanically overwrites 50% of its portfolio using ATM calls. Since a few months have gone by, let us revisit my claim to see if it is still accurate.
On a trailing 1-year basis, the QYLG ETF has returned 37.5% compared to QQQX's 35.1% return on NAV (Figure 7). On a 3-year basis, QYLG has returned 6.3% vs. 5.1% for QQQX. So my assertion that QQQX produces 'negative alpha' appears accurate.
…But Discount To NAV Presents A Buying Opportunity
Normally, the simple comparison above would be sufficient to recommend investors choose the QYLD ETF over the QQQX. However, occasionally, market dislocations can allow investors opportunities to acquire decent assets at a discount, and I believe we are currently presented with such an opportunity with the QQQX fund.
Unlike exchange-traded funds ("ETF") where fund units can be created or redeemed depending on supply and demand, closed-end funds like the QQQX have a fixed number of units that are not redeemed. When there is more selling pressure on CEFs than buying demand, CEFs can trade at significant discounts like the QQQX fund currently.
Furthermore, as the QQQX fund essentially holds just the Nasdaq 100 Index with ~50% of the portfolio overwritten with calls, its portfolio is fairly 'vanilla' and not hard to monitor / value, so its wide discount to NAV is unjustified.
Judging by the difference in historical returns, I estimate the QQQX fund has a 'negative alpha' of 1.2%-2.4% compared to the QYLG, so I can justify a modest 1-3% discount, but not a 7% discount.
Risks To QQQX
Of course, one of the downsides of call-overwrite strategies is that while it trades off the upside for premium income, call-overwrite funds retain most of the downside of the underlying index. So if the markets were to decline significantly in the coming months, the QQQX fund would have a very high downside capture.
Furthermore, there is no guarantee that the QQQX fund will close its discount to NAV. If QQQX's discount to NAV persists or widens, then the QQQX fund may continue to underperform QYLG.
Conclusion
In normal circumstances, I would recommend investors interested in call-overwrite strategies on the Nasdaq 100 Index to avoid the QQQX fund, as its 'dynamic overwrite' strategy appears to deliver 'negative alpha'. However, with the QQQX fund trading at a historically wide 7% discount to NAV, I believe its shares may provide an attractive buying opportunity for income-oriented investors, assuming its discount to NAV will close in the coming quarters. I am upgrading the QQQX fund to a buy .
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QQQX: Discount To NAV Presents A Buying Opportunity