QYLD: Risks Outweigh Upside Potential

seekingalpha03-28

Global X NASDAQ 100 Covered Call ETF has gained popularity among investors for its covered-call strategy.However, the current dividend yield of ~11.6% may not be sufficient to compensate for the ...

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It uses a covered-call strategy (more on this later) to strike a balance between income and growth potential. Admittedly, its use of covered calls puts a limit on its upside potential compared to other indexed ETFs that track the Nasdaq 100-Index (NDX) directly. However, by selling calls, this capped upside also translates to higher current income (and also potentially lower volatility during market corrections). Thus, the fund can be appealing to a variety of investors, particularly those with a shorter time horizon and those prioritizing income over long-term capital gains. Indeed, QYLD now features a dividend yield of around 11.6% as seen in the table below (on a TTM basis). On top of such a generous yield, the fund has also provided a price appreciation of about 6% in the past year, resulting in a handsome total return of ~19% in the past year alone.   Seeking Alpha Against this backdrop, the goal of this article is to explain why I think it’s time to sell and take the profit. First, investors need to be cautious of the dividend yield. To start, QYLD’s current yield is not as high as on the surface once properly contextualized. For example, as seen in the chart below, it is lower than its historical average by a good bit (its average yield in the past 4-years is 12.5%). Secondly and more importantly, I anticipate the yield to further drop given the current level of implied volatility (which is close to the 52-week low). And finally, I am also concerned about the overvaluation risks in the underlying Nasdaq 100 index. All told, the gist of my argument is that I do not think the 11.6% yield is sufficient to compensate for the downside risks. The remainder of this article will elaborate on these factors. QYLD: quick introduction I will skip basic information here and only focus on the features that are most relevant to the arguments I am about to make. First and foremost, as just mentioned, the fund uses a covered-call strategy as detailed in the fund description below: QYLD: The Global X Nasdaq 100 Covered Call ETF ((QYLD)) follows a “covered call” or “buy-write” strategy, in which the Fund buys the stocks in the Nasdaq 100 Index and “writes” or “sells” corresponding call options on the same index. Furthermore, QYLD essentially uses ~100% of its assets for call writing, and I will elaborate on the implications later.   Seeking Alpha Secondly, note that QYLD charges an expense ratio of 0.61%. This level of fees is common for funds (both ETFs and CEFs) that use the option overlay due to the additional cost of trading options. For example, Global X Nasdaq 100 Covered Call & Growth ETF charges 0.6% and Nuveen NASDAQ 100 Dynamic Overwrite Fund (QQQX) charges 0.89%. These fees are substantially higher than passively indexed funds such as QQQ. Valuation risks Let me start with the valuation risks. The current P/E ratio for the Nasdaq index sits at 29.63x as of this writing according to FullRatio. To put a broader context, the table below shows the historical P/E ratio of the Nasdaq index over the past 10 years. As seen, NDAQ's P/E ratio peaked in the Dec 2016 quarter at 106.54x, which I think is an outlier and should be excluded from this discussion. Without this outlier, Nasdaq’s current P/E of 29.63x is the highest in the past decade. Combined with other macroeconomic uncertainties (high inflation, high-interest rates, multiple ongoing geopolitical conflicts, and trade tension between the U.S. and China), I won’t be surprised by a sizable correction in the index and also in QYLD. Of course, the covered call can provide some downside correction, but I don’t think the protection would be sufficient under current conditions, as detailed next.   Source: FullRatio.com Dividend yield and option premium As aforementioned, the main mechanism for QYLD’s income generation is through the option premium. The dividend paid by the underlying index is too small (only 0.55%) and compares negligibly to the option premium. To maximize the option premium, QYLD writes options on pretty much all of its assets. More specifics are shown in the chart below. As seen, as of March 26, 2024, the fund holds a short Nasdaq call option with a notional exposure of $8.3B. In comparison, the fund’s total net asset is about $8.1B.   QYLD fund descriptions In general, I do not see anything wrong with such a strategy (which really is a tradeoff between generating current income and future price gain). However, I think the current conditions are very unfavorable to this strategy. The table below shows the implied volatility (“IV”) for QQQ options compared to its historical data. As seen, the current IV is only 15.6x. It is substantially lower than the 52-week average (17.9x) and a far cry from the peak of 24.3x. Actually, the current level is close to the 52-week low of 14.1x.   Source: marketchameleon.com Such a low IV means that options writers (such as the QYLD fund in this case) are currently receiving less premium (close to the lowest level in 52 weeks) for undertaking the risks than what has been typical. As such, the generic risks for options writers are heightened. In the case of a market correction, the lower premiums would have a harder time making up for the loss in the underlying assets. And in the case of a continued bull market, the fund’s gain would be capped because 100% of its assets are used to cover the calls already, as detailed next. Other risks and final thoughts The chart below compares QYLD and QQQ's (as an approximation to the underlying Nasdaq 100 index) gain in the past year. As seen, QYLD generated a total return of close to 19% as mentioned above. In contrast, QQQ generated a total return of more than 44%. QQQ significantly outperformed QYLD over the past year because QYLD’s use of options capped its potential gains. I have to really emphasize two things, so my point is not misunderstood. First and foremost, I am not suggesting you buy QQQ. As mentioned earlier, I see too much valuation risk here. Second, there is nothing wrong with QYLD’s strategy, either. I am sure all investors considering the fund have already made peace with the trade-off between income and growth. My point is simply that the current conditions (low volatility, high valuation risks, and high-interest rates) make the trade-off very unfavorable. Finally, there are also tax considerations for some investors at least. Unlike traditional dividend-paying stocks or ETFs, the distributions from QYLD are not simply dividends due to the nature of the option premiums. Thus, portions of the income might be taxed as ordinary income. The gains can be long term or short term depending on the funds’ holding periods of the stocks and their options’ timeframe. To close, I want to congratulate QYLD investors for a terrific return in the past 1~2 years. But I think now is a good time to take the profit. To recap, the top factors in my consideration are threefold. First, the current yield is not as high as on the surface when benchmarked against historical averages or risk-free rates. Second, the overvaluation risks in the underlying index seem too high to me currently. Finally, I am concerned that the current option premium is too low to compensate for the downside risk, especially considering the overvaluation risks.    Seeking Alpha","kind":null,"is_publish_news":null,"is_publish_highlight":null,"is_publish_live":null,"is_publish_wemedia":null,"editions":null,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.22.4","shortVersion":"4.22.4","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2422192015"}