Consider that we are bullish on using options to enhance returns. We have written about the advantages of this strategy recently as well. However, when it comes to ETFs deploying options, we generally have not found one that we like. ETFs do many things that do not align with our strategy. Today, we go over one option-enhanced fund and explain why we don’t recommend it. The Nuveen Nasdaq 100 Dynamic Overwrite Fund (QQQX) is one of the popular funds that uses covered calls as the primary strategy to enhance returns.

The Fund

QQQX was founded in January 2007 with the aim of offering regular distributions, through a strategy that seeks attractive total return with less volatility than the Nasdaq 100 Index. This was done by investing in an equity portfolio that was almost identical to the Invesco QQQ ETF (QQQ). Alongside that, the fund aimed to sell call options on 35-75% of the notional value of its equity portfolio. The longer-term average was targeted at 55%. The fund also had an “after-tax” goal in mind, and this meant that it would aim to trade less than some overactive funds out there.

Holdings

QQQX’s top holdings include familiar names like Apple Inc. (AAPL) and Microsoft Corporation (MSFT).

Source: Nuveen

You can see the substantial overlap with QQQ holdings.

Source: Invesco

There are subtle differences though, and these come into play possibly from the fund’s drive to achieve tax efficiency.

Options Income

QQQX’s options are exceptionally near-term in nature. As of September 30, the weighted average days to expiration was near 12.

Source: Nuveen

This suggests that the fund is writing a lot of weekly options and not aiming for the first monthly expirations. The 101% number above shows that the fund is selling calls on average rather close to the money. The range of 94-106% is probably as a result of the volatility of its underlying holdings rather than the fund actually writing deep in-the-money or out-of-the-money calls.

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Fees

The fund’s fees are modest for an actively managed one and one that has in place an option writing strategy.

Source: Nuveen

But they probably could be lower in this era of proliferating ETFs. It uses no leverage, and hence, direct comparisons with leveraged funds are not advisable.

Performance

Since its inception, QQQX has actually lagged QQQ returns by a rather substantial amount.

ChartData by YCharts

At market peaks, you would expect buy-overwrite funds to lag, and we are certainly close to some extreme valuations today. But we are not ready to make this excuse for QQQX. We will show why below, by examining how the fund did during severe drawdowns. Buy-Overwrite funds only outperform over full cycles by losing less in selloffs. QQQX has just failed to deliver in that regard.

Peak To Trough #1

From our perspective, the key money is made by option funds in bear markets, by avoiding losses. This is where QQQX failed miserably the first time. Just look at its performance from near the 2007 peak right till the March 2009 bottom. Note, we are looking at total return, so dividends are included.

ChartData by YCharts

QQQX outperformed QQQ by 0.27%. That appears unacceptably low.

Some of this was as a result of the NAV discount blowout for QQQX. You can see below that the NAV discount increased during this period, but even adjusting for that, the performance is rather poor.

ChartData by YCharts

Assuming the NAV discount remained constant, $100 invested in QQQX would have lost about 35.9% versus 39.67% in QQQ. This improves the numbers, but they are again lackluster.

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Peak To Trough #2

While we have had many selloffs over the years, the one in March was quite notable. Here again, QQQX delivered a rather bad performance for a hedged fund.

ChartData by YCharts

To some extent, the culprit was the widening NAV discount during a period of turmoil.

ChartData by YCharts

But here is the problem. Even adjusting for that, as in comparing NAV to NAV, QQQX was just matching QQQ.

Overall Opinion

The fund is focused in an expensive sector, and Technology and Communications comprise 70% of its holdings.

Source: Nuveen

We see in general very poor prospects for the next 10 years, and we believe a vast majority of technology shares will provide negative returns from these valuations. EV-to-EBITDA calls for a rather horrific 10-year return profile as well.

Image

So, if we were to recommend a covered call fund, at the minimum it needs to show some spine in downturns.

Why is the covered call strategy failing? Well, we have not checked day-to-day changes in this fund, but we suspect that the fund is harvesting very little premiums and the whipsaws of the market are forcing it to buy back shares at a higher price than when they are called away. It is also using very near-term options, and these options are also very close to the share price. This is a strategy we actively avoid in our own portfolios, as it only appears to produce good results, but it is very counterproductive over long periods of time. That is exactly what we see here from QQQX.

That said, QQQX has run a managed distribution scheme better than some other funds. For example, the Cornerstone Total Return Fund (CRF) has produced 2.1% compounded since 2007, versus the 10.27% compounded done by QQQX. QQQX has, of course, had the tailwind of being in the best-performing industries by virtue of trying to copy QQQ. Past performance is definitely not a guarantee of future returns for this one. We would get more enthusiastic if the fund showed an ability to dynamically outperform in strong drawdowns. Until then, we give it a “meh”.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.



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