2023-04-17 20:46:55 ET
Summary
- QYLD sells covered calls against stocks in the Nasdaq 100.
- Utilizing covered calls is a strategy best suited for neutral--not trending--markets.
- We think that the fund should be used tactically by investors looking to achieve a specific outcome as part of a broader portfolio strategy.
A Long Running Question
Over the course of one's investing life, it's almost inevitable that covered calls will become the subject of, let's say, extreme interest. After all, the premise sounds so simple. You own (at least) 100 shares of a company, and then sell a call option against those shares and collect the premium. Based on your level of bullishness on the stock you own, you select the strike price (the price at which the option can be exercised) and the time frame in which the option is valid.
Yet, the outcomes are not always so clean-cut. Proponents of the strategy say that collecting something akin to 'rent' (I.e., option premium) on positions that you don't expect to be very volatile in the short term is smart, while critics point out that covered call sellers are eliminating their greatest asset (upside appreciation potential) while retaining all of the potential downside (the fact that the stock could fall or, theoretically, go to zero).
One possible solution to this conundrum comes in the form of covered call ETFs such as the Global X Funds NASDAQ 100 Covered Call ETF ( QYLD ). Today we will examine what kind of investor this fund makes sense for. Let's dive in.
The Fund Facts
QYLD, as stated previously, is a fund which buys stocks, sells covered calls against those holdings, and then passes the overall yield on to its investors.
The fund has an eye-popping current indicated yield of 12.03%, and according to its most recent fact sheet from March 31, 2023, a 30-day SEC yield of 12.81%.
The fund makes dividend distributions monthly, which makes sense considering the fund's policy of selling at-the-money [ATM] monthly options. The fund caters to investors who seek to "generate income through covered call writing, which historically produces higher yields in periods of volatility."
The fund also--as implied in its name--limits itself to taking positions and selling covered calls against stocks listed in the NASDAQ 100. As such, the fund's fact sheet lists these companies as its top 10 positions ending March 2023.
Performance
Given that the fund states an objective of seeking historically higher yields through periods of volatility, it makes sense to view the fund's recent performance, especially since 2022 was a period of, well, volatility for a lot of Nasdaq 100 stocks.
Using a period of one year, we see that the fund has performed--on a total return basis--almost identically to the Nasdaq 100, returning negative 7.16% versus negative 7.79%. (During the same time frame the wider Nasdaq index ( QQQ ) returned negative 7.31%.)
The fund's own performance metrics over time paint a similar picture.
Indeed, over multiple time frames the fund has not beaten the market price or the hybrid index which it benchmarks itself against.
Part of the reason for this relative underperformance has to do with the overall behavior of the market. Covered calls, after all, should not be expected to perform well if the market is trending in either direction. For example, movements to the upside will mean your options get exercised, and you are now out of your position and out of our gains. Movements to the downside (as long as they exceed the premium collected) mean that you are holding your position at a loss.
Typically, only sideways markets (or stocks) tend to produce positive results for covered call strategies. Unfortunately, companies that occupy the top of the Nasdaq 100 (such as Tesla ( TSLA ), Nvidia ( NVDA ) and Google ( GOOG )( GOOGL )) aren't exactly known for staying in place.
Asset Flows
Nevertheless, QYLD has been quite popular, accumulating more than $7.5 billion in funds over the past three years (there have been outflows recently, the fund has a little over $7 billion in assets under management currently).
It's important to note that asset flows have steadied since around mid-2022, however. This in itself isn't a negative--after all, it's somewhat expected since the market experienced such intense downward volatility during that year.
However, we do think that asset flows are something that all ETF investors should be aware of. What we often see is that many ETF investors pay attention to the underlying assets in which their ETF holds, but not the plumbing of the ETF itself. Should the ETF experience sudden outflows, dislocations could occur between the price of the ETF and the expected price based on the allocations of underlying securities (and corresponding derivatives) as the two attempt to balance.
The Bottom Line
Covered calls are utilized to boost yield on a stock holding by collecting premium through the sale of a call option. In theory this sounds great, but there is a bit of a paradox at work. Buying stocks in which the market ascribes a lot of potential upside (or downside, a.k.a., implied volatility) means that there will be less premium to collect on those issues. Further, should those stocks appreciate, your ATM calls will be exercised, leaving you with the little bit of upside you gathered up front from said premium.
On the downside, the Nasdaq has led the three major indices down since January 1st, 2022 due to its heavy weighting in tech and generally more speculative constituent companies.
Thus, investors in QYLD have not seen the strategy pay off for them for the last 18 months or so. In the near term, we unfortunately do not see this trend reversing. We reiterate, however, that this fund is best suited (in our opinion) for a market that is rather stagnant. It is therefore most likely suitable for tactical use by an investor who--as part of a wider portfolio strategy--is seeking to generate extra income in a market that lacks major conviction either to the upside or the downside.
For further details see:
QYLD: Why This Covered Call ETF Isn't Paying Off