2023-07-25 18:39:22 ET
Summary
- The Global X NASDAQ 100 Covered Call ETF is underperforming due to its mechanical call selling strategy.
- The fund is up 12.6% year to date, compared to the index components it sells calls on, which are up more than 42% in 2023.
- Market conditions don't favor QYLD, and the fund's current OTM short option should only provide minimal downside protection in the event of a drop.
- QYLD's strategy has caused value destruction for fund holders in our view, and we think that investors should seek alternatives.
- TLTW is likely a better option for income seekers, and has actually outperformed its comparable, TLT, since inception.
A few months ago, we penned an article titled " QYLD: The Yield Is A Mirage ". It garnered almost 100 comments that responded variously to our main thesis, which argued that due to the fund's strategy construction, QYLD (the Global X NASDAQ 100 Covered Call ETF) was doomed to underperform in strong markets and offer no meaningful hedge in weak ones.
Fast forward to today, and our thesis continues to be proven correct.
Year to date, QYLD is up 12.6%, while the index it sells calls on is up more than 42%:
TradingView
Mind you, these ETF's have the exact same exposure; the only difference is QYLD's call selling campaign in the name of "income".
If you factor in this income, it's still plainly evident that QYLD's strategy has caused value destruction for fund holders:
TradingView
Remember, the only difference between QQQ and QYLD is the call selling strategy.
At the present moment, and despite the rally in the underlying, we still think QYLD is set to underperform.
Today, we'll dive deeper into our main reasons for maintaining a strong sell rating on QYLD, and argue why I think the fund should be dumped from the portfolios of income investors everywhere. Plus, we highlight a high-income alternative we strongly prefer.
The Fund
Before we dive into the current market conditions that make the fund a bad pick, Let's quickly recap why the fund continuously underperforms.
In case you're new to QYLD, the fund mechanically sells calls against its underlying positions to generate income.
Because the fund holds Nasdaq stocks but sells NDX options which are cash settled, the funds doesn't need to actually liquidate positions if calls settle ITM; rather, the fund simply incurs costs that dent NAV, effectively raising the cost basis of the underlying positions.
Yet, no matter where the index finishes whenever a call is sold, the ETF pays out the call premiums in the form of monthly dividends.
This mechanical, non-discrete selling is what causes losses. To see this in action, check out the following example we mentioned previously:
PropNotes
In the orange, you'll see QQQ - the underlying asset - and its performance this year. It's had, broadly, 2 strong periods, with a weak period in March in the middle. As a result, it's up ~21% so far YTD.
However, QYLD has had two tepid periods of growth (circled), and the same weak period in March. Why?
When you see QYLD's price action getting all bunched up like that, it means that the underlying assets are desperately trying to go higher (and follow QQQ), but the options the fund has sold are counteracting this P/L, causing constriction. Theoretically, these options the fund sells should be providing solid yield, and they do.
However, what it means is that every time QQQ finishes an option expiration at a higher price than the strike QYLD sold, the functional cost basis of QYLD's underlying assets increases. Sometimes, by a lot. When it comes to investing, you want to be getting your cost basis lower, not higher.
Then, in the example above, the fund sells new options, and the underlying assets are open to participate in the downside, which is only slightly protected by the option credit.
In short, the fund's strategy for selling calls causes significant increases in the cost basis of the fund's underlying stocks, which prevents capital appreciation and hurts total returns. It also provides minimal protection against sudden equity downside.
Many commented on our previous article saying something similar to the following:
Interesting article with valid points! I do think one thing that you may not be taking into account is that some of us who own this may be expecting to not be around for 20 more years. As a result we are more interested in a current income stream rather than growth.
Unfortunately, we would argue that holding QQQ instead of QYLD and selling it periodically for "income" would have a similar return profile and allow for more upside; especially considering that the fund is already effectively doing that.
Market Conditions
While we've outlined our problems with the ETF in a vacuum, the current market looks particularly pernicious for QYLD holders.
First, our market outlook is grim.
A secular rally in AI stocks and the perception of slower rate hiking going forward has allowed for index levitation YTD, with Nasdaq 100 components up ~42% YTD:
TradingView
However, leading economic data (the stuff that predicts how the future data will likely look), is weakening, which we pointed out here:
As we alluded to, net net, we remain somewhat bearish on Global GDP, including major U.S. Equities ( SPY ) as well as global stocks overall ( VT ).
Some have recently made the argument that things remain depressed, and thus good news could surprise to the upside and catalyze a rally. However, considering that things are mostly still getting worse from a rate of change perspective (including the U.S. PMI diving to ~46!), we're not ready to buy into that narrative yet.
Combined with a pricey overall valuation environment, and the risk seems firmly to the downside at this point. We think that trimming positions here and waiting for a clearer macro-outlook is the best course of action.
On top of that, the stocks that have powered the massive rally ( AAPL , NVDA ) look overbought and overvalued:
However, as [Nvidia] shares continue to climb to dizzying heights, we're beginning to get concerned about the valuation, especially against the broader macroeconomic backdrop.
Apple remains a highly profitable company, but the stock is currently overpriced and set to drop due to market saturation for its products and an extremely overbought technical condition.
It isn't just Nvidia and Apple either; Microsoft ( MSFT ) also looks extended, with a free cash flow multiple scraping the upper historical deviation at ~45x:
TradingView
While the Nasdaq 100 has undergone a historical rebalance as a result of the rally in these top stocks to mitigate future risk associated with this concentration, make no mistake; QYLD's underlying NAV is heavily tied to the performance of the Mega-cap names we're all familiar with.
Some may argue that this is a perfect time for QYLD to outperform, but we think that the fund's current position won't afford much protection.
Right now, QYLD is short $8.3 billion of 15,475 strike NDX call options expiring in a month:
QYLD
The position's current moneyness is 99.7%, which means that the options are still out of the money, or "OTM". As we all know, OTM options have a lower delta, which means that they "protect" principal less and less as stocks drop before option expiry.
Once the momentum in the mega caps runs out, we fear that the setup is similar in some ways to the Covid related drop of 2020:
TradingView
In that scenario, the option the fund was short expired in late February, just in time to allow the fund's assets to participate in a full drop. Then, at lows, QYLD sold another call, which hampered NAV from recovering with QQQ.
While a drop in the current market may be less severe than the dramatic selloff in 2020, the idea remains that the fund will likely sub-optimally position around a drop, which would cause continued value destruction.
How QYLD Wins
As we've explained, the fund underperforms in up markets and quick drops. What about sideways markets?
As it turns out, sideways or grindy/down markets are relatively good for QYLD:
TradingView
In 2022, which was a down / grindy year, selling calls was an optimal strategy for once. This is the fund's main win condition.
However, the issue with this is that QQQ, in reality, for the most part, is rallying or crashing. It's a higher beta index than SPY, which means that it's going to be a suboptimal place to sell calls, especially in a non-discrete manner.
Plus, while the fund did outperform in 2022, QYLD will require an extremely long period of time where stocks trade sideways in order to "catch up" with QQQ's total returns:
TradingView
Alternatives
Between the issues with long term underperformance and current market conditions that could catalyze a drop, we maintain our strong sell rating on QYLD.
That said, we know that there's a market for people who want significant yield from option strategies. To us, the iShares 20+ Year Treasury Bond Buywrite Strategy ETF ( TLTW ) seems like a much better option.
The fund operates much like the QYLD and pays more than 13% in yield, but instead of writing calls on QQQ holdings, it writes calls on TLT holdings:
The investment seeks to track the investment results of the Cboe TLT 2% OTM BuyWrite Index that reflects a strategy of holding the iShares 20+ Year Treasury Bond ETF while writing (selling) one-month call options to generate income.
Bonds are a more favorable instrument as they tend to move more slowly than stocks, and TLTW has actually outperformed TLT since inception:
TradingView
For those who want income and stronger principal protection without the aforementioned issues, it could be worth looking into further.
Summary
All in all, QYLD remains a "strong sell". We expect the fund's strategy to underperform in most market types, and present market conditions don't favor the ETF's underlying components. Additionally, we're concerned about the present OTM short option situation which could provide minimal protection in the event of a sudden market drop or turn of momentum.
For those looking for a similar high-income vehicle that boasts less volatility and a better track record, TLTW may be worth a deeper look.
Cheers!
For further details see:
QYLD: Substandard Returns Set To Continue