The market has become more difficult to navigate in recent months. With prices still high, consumers beginning to pull back, and political uncertainty rising, the investing environment has become much more precarious this year.
An increasingly common form of ETF focuses on providing income investors with regular payouts are covered call funds. There are several different versions of these investments, and these exchange-traded funds focus on selling monthly call options against existing holdings to generate sufficient income to make regular monthly payments. One more well-known covered call fund is the Global X Nasdaq 100 covered call ETF (NASDAQ:QYLD).
QYLD has offered investors total returns of 34.28% over the last 5 years, while the S&P has offered investors total returns of 95.52% during the same time frame. QYLD is designed to offer regular and consistent income, not maximize total returns.
I last wrote about QYLD in March of this year, and I rated this fund a buy. I am upgrading my rating of this ETF to a strong buy today. I expect volatility levels to increase significantly in the overall market over the next year for multiple reasons, and price movement in the NASDAQ should become much more uncertain moving forward as well. The VIX is at the low end of the historic range seen for volatility, the premiums in the monthly call options QYLD sells against the fund’s core holding should continue to rise in the back half of 2024.
QYLD has an expense ratio of .61%, $8.11 billion in assets under management, and a forward yield of 11.50%. This ETF has holdings of 51.39% in the technology sector, 15.11% in the communication sector, 12.50% in consumer cyclicals, 6.16% in consumer defensives, 6.54% in health care, 4.49% in industrials, 1.19% in utilities, .49% in energy, .41% in financials, and .22% in real estate. QYLD’s largest holdings are Microsoft (MSFT), Apple (AAPL), NVIDIA (NVDA) and Amazon (AMZN). These four positions make up 29% of the fund’s overall holdings.
QYLD uses as a strategy of selling at-the-money monthly call options against the Nasdaq 100 that the fund owns. The ETF then distributes the monthly payouts as income to investors. This fund uses the same strategy each month regardless of market conditions. The income generated from selling the options is taxed at 60% capital gains, and 40% as short-term gains.
The fund’s monthly payouts have ranged from $.16 a month to $.18 a month over the last 14 months. The ETF’s payouts have ranged from .26 a month to .10 a month since the fund’s inception in December of 2013, primarily as the implied volatility premiums in the monthly call options this fund sells have varied depending on market conditions.
The VIX is currently at the lower end of the index’s 5-year range.
There are multiple reasons to believe overall volatility levels will likely rise significantly in the back half of this year in the overall market, as well as more specifically in the NASDAQ 100. Recent data indicates an increasing pullback in consumer spending. Higher rates have made borrowing more difficult, wages have not kept up with increased prices, and many consumers have now fully depleted COVID-19 savings. Consumer spending slowed in the final revised first quarter GDP estimate from 2% annual growth to 1.5% annual growth. There is also evidence that lower income earners in particular are starting to trade down and be much more cautious with their spending as well, with Target (TGT) and Walmart (WMT) showing this trade down. McDonald’s (MCD) also recently reported a significant drop in spending by lower-income consumers as well.
There is also a Presidential election in the US that is set to occur in just four months, in addition to boiling geopolitical tensions in the Middle East The most deadly recent rocket attack since October 7th occurred this week in the Golan Heights. Big-cap tech companies that make up the NASDAQ 100 also get nearly 60 percent of these company’s earnings from outside of the US, and the dollar could move significantly if the economy continues to weaken or conflicts abroad become more volatile. QYLD paid out over $.20 a month during a more volatile period in the market in 2021 and 2018, which would be a near 15% increase in payouts from current levels.
Many leading tech companies are also pricing in very optimistic earnings expectations. Microsoft is currently trading at nearly 38x expected forward earnings, while the company’s 5-year valuation average is 31x predicted forward earnings. Apple is also trading at 35x expected forward earnings, while the company’s 5-year average valuation is 27x predicted forward earnings.
This fund does have significant downside risk. QYLD sells calls, but the fund does not purchase any puts or use other hedging or risk-management, investors losses can be unlimited. The strategy this fund uses also creates loss in the net asset value, and the NAV will decline over time, though the payouts have always exceeded the erosion of the principal since this exchange traded fund’s inception in late 2013.
While QYLD has underperformed other covered call funds such as JEPI over the last 5 years, this fund should benefit significantly from increased volatility levels in the back half of the year. The ETF’s strategy of selling at-the-money calls does leave investors vulnerable to downside risks, but this fund is designed for long-term investors whose primary goal is regular income, and most big-cap tech companies have still been able to operate well even in difficult economic environments. With market conditions likely to deteriorate over the next year, QYLD should be able to offer patient individuals substantive income without excessive risk to the principal.
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