To The Moon

Summary

• Defiance Nasdaq 100 Enhanced Options Income ETF offers a headline distribution yield of 52.6% by systematically writing daily put options on the Nasdaq 100 Index.
• QQQY ETF's put-write strategy is similar to buy-write strategies, but it may outperform in a rising market as its written puts are less likely to expire in-the-money.
• Despite its high distribution yield, the QQQY ETF still suffers from a capped upside/uncapped downside problem and underperforms the QQQ over the long run.

AndreyPopov

Investors' appetite for 'high-yielding' investments never ceases to amaze me. Case in point is the Defiance Nasdaq 100 Enhanced Options Income ETF (NASDAQ:QQQY), with a headline distribution yield of 52.6% (Figure 1).

Figure 1 - QQQY has a headline yield of over 50% (defianceetfs.com)

When I first saw adverts for the fund in late 2023, my initial thought was that the QQQY ETF was doomed to blow up, since it sells at-the-money ("ATM") and in-the-money ("ITM") puts every day using zero-day-to-expiry ("ODTE") options.

However, I did not want to be too rash in my judgment, so I decided to hold off on writing about the fund and give the QQQY ETF some time to season itself. To the fund manager's credit, the QQQY has defied my initial reaction and early criticism and has not blown up. But does it truly yield 50%+, or is that merely a marketing point?

I believe investors need to look beyond the headline yield of the QQQY ETF and realize that functionally, its strategy and performance are similar to that of a buy-write covered-call strategy.

QQQY's strategy of selling puts may outperform covered-call funds in a rising market, but the opposite should be true in a bear market. Overall, I am personally not a fan of the QQQY as it gives up too much upside exposure.

Fund Overview

The Defiance Nasdaq 100 Enhanced Options Income ETF is the first 'put-write' ETF using daily options seeking to deliver enhanced yield for investors. The QQQY ETF systematically writes daily put options on the Nasdaq 100 Index. The proceeds are then invested in U.S. treasury securities.

In the 9 months since its inception, the QQQY ETF has already garnered over $260 million in assets due to its high distribution yield (Figure 2). The fee charged by QQQY is relatively high at 0.99% expense ratio.

Figure 2 - QQQY overview (defianceetfs.com)

Figure 3 shows QQQY's portfolio holdings as of July 3rd. Readers should note that since the QQQY writes daily options, most of its option positions expire at the end of every day and do not show up in the daily holdings, report.

Figure 3 - QQQY daily holdings (defianceetfs.com)

Instead, readers should refer to the intraday trading report to see what options are being traded (Figure 4).

Figure 4 - QQQY intraday trading report (definanceetfs.com)

Writing Puts Is Similar To Covered Calls

Unlike other more popular high-yielding derivative funds on the market like the JPMorgan Nasdaq Equity Premium Income ETF (JEPQ) and the Global X Nasdaq 100 Covered Call ETF (QYLD), the QQQY ETF employs a 'put-write' strategy instead of a 'buy-write' strategy.

The mechanics of a put-write strategy are relatively straightforward. The profits of a put-write position are the same as owning the underlying security between the 'breakeven' point ($67 in Figure 5 below) and the option strike price ($70 in Figure 5). If the security's price rallies beyond the strike price, the strategy's profits are capped at the option premiums received. Alternatively, if the security sells off below the breakeven point, the strategy will lose money at a 1:1 ratio to the underlying security.

Figure 5 - Illustrative put-write strategy (investopedia)

Technically, the payoff from a 'put-write' strategy is equivalent to a 'buy-write' strategy, where the investor holds the underlying security and writes call options against it (Figure 6). In both instances, the upside of the strategy is capped, while the downside is uncapped.

Figure 6 - Illustrative buy-write strategy (investopedia)

However, in practice, there are a number of subtle but important differences between the put-write strategy vs. the buy-write strategy. First, investors generally want downside protection, so puts are often more expensive than calls. So QQQY's strategy of systematically selling puts may be able to capture this inefficiency.

Second, in a generally rising market, a strategy that systematically writes puts may outperform a buy-write strategy, as there is less chance of the puts expiring ITM and requiring a cash outlay to close.

Put-Write Still Misses The Majority Of The Upside

However, the main issue with both buy-write and put-write option strategies is that upside returns are capped while downside returns are uncapped. Over the long run, this skewed returns profile will cause both strategies to underperform a simple buy-and-hold strategy.

For example, since its inception, the QQQY ETF has delivered 18.9% in total returns compared to 31.1% for the Invesco QQQ ETF (QQQ), which is also based on the Nasdaq 100 Index (Figure 7).

Figure 7 - QQQY vs. QQQ, since inception (Seeking Alpha)

Look Beyond The Yield

Another criticism I have of the QQQY ETF is that its total return is much lower than its headline yield. For example, since its inception, QQQY has delivered only 18.9% total return compared to its monthly yield of ~5%.

What is going on is that even though the Nasdaq 100 Index has been in a strong bull market, it still has down days. In fact, approximately 47% of the QQQ ETF's daily returns have been negative in the past 3 years (Figure 6).

Figure 8 - QQQ daily returns distribution (etfreplay.com)

When returns are negative, the QQQY ETF must settle with the option exchanges at the end of the day with a cash outlay to cover the difference between the closing index price and its option strike price. This reduces the net asset value ("NAV") of the fund. Over the long run, even though the fund generates very high 'income' from selling daily put options, it must 'liquidate' its NAV about half the time to settle its accounts. Investors can observe this effect in action by noting that the fund's NAV has shrunk by 26% since its inception (Figure 9).

Figure 9 - QQQY has a shrinking NAV (morningstar.com)

Alternatively, the fund's 19a notices show that 47.1% of the QQQY ETF's distribution in the fiscal year-to-date can be considered 'return of capital' ("ROC") (Figure 10).

Figure 10 - About half of QQQY's distribution is categorized as ROC (defianceetfs.com)

Is QQQY A Good Yield Fund?

So is the QQQY ETF a good fund to buy? The answer is, like many things in finance, it depends. If we are in a strong bull market, like what the Nasdaq 100 has been experiencing recently, then writing ATM put options may be a better strategy than writing ATM call options like that of the QYLD ETF. For example, QQQY has outperformed the QYLD ETF since its inception, returning 18.9% compared to 12.6% (Figure 11).

Figure 11 - QQQY vs. QYLD, since inception (Seeking Alpha)

However, both severely underperformed the QQQ ETF at 31.1%, because their daily returns are capped.

On the other hand, the QQQY has underperformed the JEPQ ETF since its inception because JEPQ writes out-of-the-money ("OTM") options, so it is able to capture more of the index's upside (Figure 12).

Figure 11 - QQQY vs. JEPQ, since inception (Seeking Alpha)

Finally, although we have not seen how the QQQY ETF performs in a bear market, I suspect the QQQY ETF will underperform the QYLD and JEPQ, since its puts sold will more likely end up 'in-the-money'.

Figure 12 compares the headline distribution yield of the 3 'high yield' derivative income funds based on the Nasdaq 100 Index.

Figure 12 - QQQY vs. QYLD and JEPQ, yield (Seeking Alpha)

Overall, investors choosing the QQQY ETF over its peers are making an inherent market bet that the Nasdaq 100 Index will be heading higher. If that is the case, then I believe the JEPQ is the better product, since it is better able to capture the underlying index's upside while still paying a 'high' distribution yield.

Conclusion

The Defiance Nasdaq 100 Enhanced Options Income ETF aims to generate high yield for investors by systematically writing daily put options on the Nasdaq 100 Index.

In general, while QQQY's strategy may sound scary, since it is selling daily downside protection, it is functionally similar to buy-write strategies like the QYLD and JEPQ ETFs. However, in a rising market, QQQY may outperform the QYLD as its written puts are more likely to expire out of the money.

However, QQQY still suffers from the capped upside issue that afflicts both 'buy-write' and 'put-write' strategies. If the market rallies rapidly in a short period of time, the QQQY ETF's strategy will underperform as its upside is only from premiums received and treasury yields.

Personally, I am not a fan of the QQQY ETF as over the long run, the strategy's capped upside and uncapped downside will cause it to underperform the QQQ. I rate it a hold.