QQQY: Unacceptable 105% payout ratio from this Nasdaq fund

thesis

The Nasdaq 100 Enhanced Options Income ETF (NASDAQ:QQQY) is a fairly new exchange-traded fund that received its IPO in September 2023. The name is part of a growing suite of products that aims to extract dividends from widely used indices by option structures:

QQQY aims to deliver consistent monthly return distributions to investors along with equity market exposure to the Nasdaq-100. QQQY is an actively managed, high-income, exchange-traded fund (“ETF”) constructed from treasury and Nasdaq-100 index options. The objective of the strategy is to generate huge monthly distributions by selling option premiums every day. The fund uses daily options to achieve a rapid time decline by selling in the money.

Unlike other Nasdaq funds that use covered calls, QQQY uses cash covered puts as a strategy. The name is reminiscent of the S&P 500 ETF WisdomTree PutWrite Strategy Fund (PUTW), which we covered Here.

In today’s article, we’ll take an in-depth look at QQQY’s construction, distribution, and analysis, and explain why we don’t think this is a robust name to use in monetizing the Nasdaq index.

What does QQQY actually do? Writing put options

Unlike covered call funds, QQQY does not buy the Nasdaq index directly, but instead writes cash covered puts:

In the table above, which shows the fund’s holdings as of September 11, 2024, we can see that the ETF is parking its cash in Treasuries, all while writing cash-covered trades on the Nasdaq. In this case, the fund took a put on the Nasdaq with an expiration date of September 11, 2024 and a strike of 18,910. If the index is above this level at the close of business, the fund pockets the premium; otherwise, it records a loss.

In a bounded or upsloping market, the fund will realize gains through offset premiums on supported put options. Conversely, in a bearish market, the ETF will experience losses as bids expire with the market less than the strike level. However, even in a falling market, the fund will have a slight buffer for a direct position through the option premium built into the strategy.

Essentially, like PUTW, QQQY engages in a systematic put strategy on the Nasdaq index.

Total strategy return versus total positioning

The ETF has a limited history, and we can’t show readers how the fund performed in a down market, but we can look at what the name has done in the past year since it was issued:

We use a total return function for our analysis because QQQY has a very high distribution rate (distribution which will be discussed in the next section). We compare the ETF to the Invesco QQQ Trust (QQQ) and the Global X Nasdaq 100 Covered Call ETF (QYLD).

QQQY has performed fairly in line with QYLD over the past year, with a total return of around 12% over that time frame. The name shows higher volatility compared to QYLD and was able to monetize a higher percentage of growth in June-July 2024.

As with any option strategy, QQQY cannot replicate the full advantage presented by Nasdaq given its structure. The fund can only make the option premium it underwrites through cash covered puts, so rapid upward movements in the index are not reflected. The ETF will thrive in a slow-rising market where the index makes slow gains, allowing the fund to write a large number of puts and monetize them.

Distribution not supported

What we don’t like about this fund is its unsupported distribution that uses a marketing gimmick to get attention:

When a retail investor looks at the fund’s website (or any third-party data provider), they will see a distribution ratio of 105%. That figure isn’t real and certainly doesn’t match the 12% total return the fund has posted over the past year.

How can an ETF have a 105% distribution rate then if it doesn’t make that money? The answer is “return of capital” or “ROC”. ROC is a very familiar concept in the CEF world, where funds use it to compensate for cash mismatches, or periods of time when the returns on the underlying assets don’t match what they aim to pay investors. ETFs can also have ROCs:

If we look at the fund’s Notice 19a for August 2024, we will see that 93% of the distribution for that payment date is return of capital. ROC simply means you get your money back. It is not a real return generated by the fund.

The ETF only makes money in two ways:

• interest from U.S. Treasuries held
• put option premiums

When these two sources of income do not generate enough earnings for a month, the fund simply uses investors’ capital to offset the remainder of the distribution payment. The net result of this tactic is a steadily declining price for the fund.

We don’t like this gimmick and would prefer to see the fund distribute what it does rather than target a high distribution ratio to attract new capital into the name based on unsupported distribution rates.

What’s next for this name?

Given the over-distribution feature, expect the price to continue to fall, while the fund will have a high monthly distribution rate. The name will have a very similar downside to the Nasdaq, so a hard landing scenario would see the name suffer significant losses. For example, the Nasdaq is down -32% in 2022. If that scenario were to repeat itself, expect QQQY to decline in a similar fashion, but with a 5% to 7% buffer to account for the premium of compensated option. So expect an approximate performance of -25% to -27%.

Conversely, in a rising market the fund will record about half of the gains recorded by the index, largely determined by the speed of the upward movement and the volatility associated with the macro scenario.

Conclusion

QQQY is an exchange traded fund. The name aims to generate a high monthly income figure by writing puts on the Nasdaq index. While this systematic writing strategy is brave, its application in this case is not. QQQY uses a very high ROC figure to generate a high monthly distribution rate, a distribution that is not supported. The net result is a steadily declining share price and a 1-year total return that is only 12% against a stated distribution ratio of 105%. The fund performs similar to a covered call write fund with similar downside to the index but with capped growth (about half the index’s performance over the past year).

While we like the concept of a systematic strategy of writing money on the Nasdaq, we don’t like the implementation and would prefer to see the fund reduce its distribution ratio to eliminate all ROCs and only pay what it does. Until the name structure changes to adjust the distribution rate, we rate this fund a ‘Sell’.