QQQY ETF: Surprisingly Solid Strategy, But Overambitious Distributions (NASDAQ:QQQY)

Last year, one of the most significant developments in the income ETF space was the launch of the Defiance Nasdaq 100 Enhanced Options Income ETF (NASDAQ:QQQY). This ETF was the first to sell the NASDAQ 100 put daily options to generate income and has piqued the interest of many investors by claiming a minimum target income of 0.25% per day. Unfortunately, a year has passed and many investors have noticed that QQQY’s 90% payout ratio has come at the price of NPV. As a result, Defiance announced a 1 for 3 reverse stock split for QQQY and two of its other similar funds. That said, if you look at the total returns, you’ll see that QQQY actually had a positive return. Thus, I decided to look deeper into QQQY and analyze its mechanics. What we discovered is that QQQY’s put option strategy is surprisingly solid and that there is a world where you can do well with this fund. Today, I’ll share my findings, the strategy you can use with QQQY to maintain NAV, and finally why I don’t recommend using that strategy and selling QQQY.

Surprisingly solid strategy

For those unfamiliar with the QQQY strategy, the fund sells daily 0-day-to-expiry (0DTE) put options on the NASDAQ 100 through Nasdaq-100® PM-Settled Index Options (NDXP). These put options are either at-the-money or 1-5% in-the-money according to the QQQY prospectus:

Each day, the Fund will sell put options that are priced either at the money or up to five percent in the money (ie, higher than the current market price).

These monetary adjustments are made based on their goal of generating a minimum return of 0.25% daily. If the income is not high enough on a given day, QQQY will sell more aggressive put options to generate higher option premiums, even if it is a total loss.

The fund aims to make monthly distributions. To enable this, the Fund seeks to generate a consistent stream of income on a daily basis. In particular, the Fund sells in-the-money put options to earn a minimum daily income of 0.25%. If the Sub-Adviser determines that this 0.25% daily income is not achievable, the Fund will sell options that are valued at current market value to attempt to maximize the available daily income. If potential daily income exceeds 0.25%, then the Sub-Advisor will select a target strike to seek an equal mix of current and potential income.

When I saw this strategy last year, my first thought was that the fund would have more unprofitable days than profitable ones and would quickly erode its NAV through repeated losses. After testing the strategy, however, I was surprised to see the results. QQQY’s strategy of selling 0-5% 0DTE in-the-money put options has actually been a profitable one over the past year. Using historical NDXP option prices, a hypothetical initial balance of $1.6 million on September 8, 2023 would be worth $1.92 million today, for a total return of 20.2%.

We started this backtest by collecting historical option prices for NDXP put options at 0%, 1%, 2%, 3%, 4% and 5% in the money, rounded to the nearest $100. At the time, $1.6 million was the required collateral to sell an NDXP put, and a minimum daily income of 0.25% meant that I needed to collect at least $4000 in option premiums daily. So I quit selling at-the-money, put options and moved further into-the-money any day if I couldn’t meet the $4000 minimum. Then, based on the closing prices of the NASDAQ 100, I would cash out if necessary and add the total profit or loss to the cash balance. Of the 250 tradable days, 171 were profitable, while 79 were unprofitable, for a win percentage of 68.4%. It is also good to note that the average profit and loss generated in one day was $9,551 and ($16,414), with the maximum and minimum profit/loss being $60,195 and ($69,231).

Of course, the data is not perfect and should only be used to see the big picture. You should expect QQQY to outperform these results, even after the 0.99% management fee. The reason is that I have not taken into account the interest earned from placing collateral in Treasury bills and bonds, and that QQQY may be selling options at better prices than the historical data I have. For example, the put option on the following chart of QQQY’s Top Holdings was sold at $160.50 per contract, while I was limited to $140 using historical option prices.

All things considered, QQQY’s 0DTE put options strategy is not the fund’s biggest weakness. Some improvements could be made, but overall the strategy has come out ahead, at least in the last year. The real problem lies in the overly ambitious distribution rate.

The minimum income of 0.25% per day is too much

While aiming for a minimum income of 0.25% daily is somewhat manageable, distributing it is far too ambitious. As soon as I add a drawdown factor of 7.5% (0.25% times 30 days) of cash balance in my backtest, you can see how QQQY distributions quickly erode their NAV. An opening balance of $1.6 million is worth just $737 million by the end of a year, compared to $1.92 million if no cash was distributed.

It’s no coincidence that every sharp drop in QQQY’s price is on its distribution date, and if you look closely, the drops are generally much larger than the fund’s gains in a given month.

QQQY would do much better if they didn’t stick to their 90% distribution targets and opt for more conservative revenue targets. Including out-of-the-money puts (strike prices below the current NDX price) would help them have more profitable days for more stable returns, even if the option premiums received are not as high because they do not capture intrinsic value .

Reinvest what you don’t need

Although QQQY looks like a fund that will continue to decline in due course, there is an argument that you can reinvest in this fund to preserve market value while reducing your cost basis. The point is that most investors don’t necessarily need or should use QQQY’s entire 90% distribution. For example, a 90% distribution from $1 million in QQQY would equal approximately $900,000. If you’re a retiree with $1 million and you have an income target of $100,000 a year, there’s a surplus of $800,000 that you don’t necessarily need and could reinvest. With that in mind, I decided to do a hypothetical study on QQQY, where I reinvested some of the distributions to try to maintain around $10,000 in market value.

The results were astounding. Using this reinvestment strategy would have allowed you to still receive over $2,000 in distributions for a distribution rate of about 23% while only losing about 5% of your market value. For comparison, JEPQ has gained 6.7% over the past year in market value, but distributed just 9.9%. There is a world where you can reinvest even more in QQQY for positive market value while collecting higher premiums. However, there are some problems with this approach.

The problems

First, distributions become wildly inconsistent when you try to maintain market value as well. While total distributions at the end of the year were very large, there were several months where you had to reinvest all distributions to maintain market value.

For many income investors, stability is a non-negotiable. With this strategy, you either deal with asset price volatility or distributions, which may make the fund unattractive to many. Also, given that most people will not use this strategy and another large number of QQQY investors will opt to reinvest distributions in other assets, it becomes a question of how long people are willing to continue to support a fund of whose NPV has and will only continue to decrease.

Taxes should also be mentioned here. If any QQQY investment is made outside of a tax-sheltered account, portions of QQQY distributions are subject to ordinary income taxes, which can significantly erode your returns.

NAV will continue to fall

Although I was pleasantly surprised by QQQY’s positive returns, I have to rate this fund as a ‘Sell’ as its value will continue to decline without significant changes to its strategy. Selling in the money and distributing at around 90% is way too aggressive and unsustainable, especially if the market starts to slow down like it did. Yes, QQQY will collect higher option premiums during periods of higher volatility, but a falling market would result in more put options being exercised and increase the losses QQQY incurs from settling their positions. For most buy-and-hold investors, QQQY simply isn’t the right fund unless Defiance decides to lower its target distribution to a more sustainable one.