Two of the most popular investment strategies today are growth and high-yield. Growth investing usually consists of buying technology giants like Apple (AAPL) or Amazon (AMZN) that have high revenue growth rates. High-yield investing is simply buying companies that pay the highest dividend yields in order to generate an income.
Given the popularity of these two strategies, it comes as little surprise that investors look to combine them. One way to do so is the Nuveen Nasdaq 100 Dynamic Overwrite Fund (QQQX) which owns the Nasdaq 100 (QQQ) and writes calls against it in order to generate an income.
QQQX still owns essentially the same underlying portfolio as QQQ. This includes Apple, Microsoft (MSFT), Amazon, and Google (NASDAQ:GOOG) (NASDAQ:GOOGL) which collectively make up 49% of its current equity portfolio. The fund sells calls against these assets which are usually around 3% out-of-the-money with 13 days to expiration. This means any appreciation above 3% (over a 13-day period) is capped. Importantly, not all assets are overwritten with currently 32% being free.
Does The Overwriting Strategy Generate Alpha?
At its core, writing calls is akin to selling insurance. As long as the underlying asset does not decline in value, you’ll receive steady cash flow. However, since you don’t own any appreciation, upside reward is limited while you’re still left exposed to downside risk.
This is why QQQX is trading at nearly the same price as it was since inception, even though the Nasdaq 100 QQQ is up nearly 500%. However, from a Total Return perspective (which includes compounded dividends), QQQX is up about 300%. See below:
Even with dividends, it is clear that QQQX has generated lower returns than QQQ. Personally, I believe it is fine for an asset or fund to generate subpar returns briefly since performance often mean-reverts. However, it is problematic when there is a consistent trend toward underperformance.
In the case of QQQX, the underperformance trend is relatively consistent. QQQX has outperformed QQQ on a total return basis for brief periods, usually during market crashes or corrections. However, no periods of outperformance have been sustained, and it has underperformed considerably in recent years. This is shown through the total return ratio chart below:
As you can see, QQQX not been a great investment. Particularly compared to the Nasdaq 100 whose underlying downside risk it is exposed to. Again, there are brief periods of outperformance during market crashes which is attractive, but the overall trend is clearly negative.
There are a few reasons for this underperformance. Chiefly, the call option selling strategy has become too popular and has pushed implied volatility levels too low and skew too high. Implied volatility is essentially the premium paid to call writers. When uncertainty is high, premiums rise as more people want to buy protection. Additionally, most want downside risk protection (a put) as opposed to upside protection (a call). This makes premiums higher for puts than calls which are measured in the CBOE SKEW index.
As you can see below, implied volatility levels have generally declined from 2010 to 2020, and Skew levels have risen:
In simple terms, this means call-writing premiums do not appropriately compensate for the strategy’s risk. This has naturally led to underperformance in QQQX, which will only change once Skew levels fall lower and if implied volatility remains high. The charts above suggest we may be seeing this shift.
The second reason for QQQX’s underperformance is likely its higher expense ratio. This is currently 95 bps which is far higher than one would get in a Nasdaq ETF like QQQ (currently 20bps). Considering QQQX pays a 6-7% yield, this may be an acceptable cost, but it will lead to underperformance.
Technology Stocks May Be In A (Peaking) Bubble
From 1990 to 2000, high-growth technology stocks dominated the markets. The Nasdaq 100 rose at a record pace and, toward the end of the bubble, many new investors entered the market and pushed prices to extremes. In 20/20 hindsight, this was fatal as the Nasdaq 100 subsequently lost 80% of its value.
2020 is perhaps not so different. The Nasdaq 100 recently rose at an extremely rapid pace, and fund group is currently trading at a weighted-average “P/E” over 30X. While QQQX has not risen at the same pace, the fund has nearly the same downside risks as does the Nasdaq 100.
In fact, if we take the price of QQQ and divide it by the steadier small-cap Russell 2000 ETF (IWM), we can visualize this bubble quite well. As you can see below, the ratio has risen back to its 2000 peak which proceeded the 80% decline in QQQ:
Now, this does not necessarily mean history will repeat, but it is an important pattern that investors should keep in mind. Irrational exuberance is dangerous, and it seems to dominate the Nasdaq 100 today. If anything, the extreme trend higher in QQQ that has kept QQQX’s dividends strong will likely end. Valuations have reached extreme, and today’s difficult economic environment is likely to bring them even higher through a decline in earnings.
The Bottom Line
It goes without saying that QQQX is attractive. The fund offers the allure of technology with a higher yield than junk bonds and preferred equity. While many, including myself, have demonstrated that QQQX’s premiums today do not appropriately compensate for its risk, the fund has continued to deliver decent performance on the back of the Nasdaq’s stellar performance.
Indeed, there is likely more than one reason for Nasdaq’s stellar performance over the past few months. Chiefly, most of its firms have higher “earnings inertia”, which is a term I use to describe companies that generate subscription-like revenue. For example, auto-makers have extremely low earnings inertia since people stop buying cars during difficult times. However, a company like Google generates significant business-to-business and subscription-based revenues, so its earnings will take a longer time to decline, given a recession.
The market has generally interpreted this as “Technology Stocks are COVID-Proof”. However, as we recently saw with Netflix (NASDAQ:NFLX), this is not entirely true. These companies’ fundamentals simply lag the broader economy by a few months. I believe that, as the market comes to this realization, the Nasdaq 100 will significantly underperform other equity indices. Further, this may cause QQQX to decline back to its March lows or perhaps even lower.
Still, if there is a considerable rise in implied volatility, QQQX could be a better option than QQQ. Not today when implied volatility is low (given the situation), but after the market declines for a few weeks. At this point, premiums will likely rise as they did in March can cause QQQX to generate alpha. Thus, I believe QQQX is a solid “sell now, buy-on-crash” investment.
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Disclosure: I am/we are short AAPL,NFLX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.