To be clear at the very start, the Nuveen NASDAQ 100 Dynamic Overwrite (NASDAQ:QQQX) is not just one of those funds such as the ProShares Ultra QQQ ETF (QLD) which holds Nasdaq stocks and allows you to profit from an uptrend in the value of technology stocks, possibly after being inspired by the recent acquisitions made by Cathie Wood of Ark Invest.
Instead, it provides dividends and makes use of covered calls to protect from market downsides. For this purpose, as seen in the total returns orange chart below, it has dipped less than the tech-heavy Invesco QQQ ETF (QQQ) during the last year. For investors, total returns measure the price performance plus the dividends in case these are reinvested.
In addition, for those who are allergic to covered calls, I have also included the Pacer Trendpilot 100 ETF (BATS:PTNQ) which, as seen in the pale blue chart above has delivered a higher degree of success in protection against volatility with a downside of only 10%.
However, the data from these charts are not sufficient to make a decision and my objective with this thesis is to make a comparison between the two ETFs, with a view to determining which provides the best protection against downturns, especially in the current volatile market conditions.
New Market Conditions Need A Different Approach
As was evident during the Jackson Hole symposium at the end of August, the Federal Reserve is ready to “do what it takes” in its fight against inflation, even to the point of inducing a slowdown in the economy. After being behind the curve (in fighting inflation) in the first half of the year, the objective is now to avoid stagflation at all costs. Moreover, interest rates moving higher while the Federal Reserve is also reducing its balance sheet is detrimental to tech stocks which rely on high levels of cash to finance their higher growth levels compared to more cyclical companies. At the same time, the strong dollar constitutes headwinds for tech sales to the rest of the world.
As a matter of fact, while the Nasdaq has suffered by above 22%, the damages have been more limited at less than 13% for the S&P 500 as shown in the blue chart below.
This calls for a change in mindset implying moving away from a strategy that consisted of profiting from the momentum of the Nasdaq, buying the dip, and selling the bounce. Along the same lines, holding the stocks of mega-cap tech for capital appreciation purposes worked well for more than ten years, but things have now changed with volatility looking to be the new constant.
In these conditions, some may opt for more “value” names, but with the possibility of a recession looming, the more cyclical stocks may have a hard time ahead. Thus, “high growth disruptive tech” forming part of the Nasdaq has not completely lost its shine. To this end, famous investor Cathie Wood spent over $40 million on purchasing tech stocks some two weeks back. However, given that not everyone has her “flair”, it makes sense to venture into tech but adopt some moderation, and also get some income in the process.
For this purpose, I start by assessing the merits of the Nuveen ETF.
QQQX, its Covered Calls, and High Yields
QQQX seeks to provide a total return that is less volatile than the Nasdaq 100 Index. It does so, firstly, by investing in stocks that replicate the price movement of the tech-heavy index and, secondly, through selling call options varying from 35% to 75% of the value of the underlying fund’s value, with the mid-point of 55% constituting a long-term target (figure below).
For those who are not familiar with covered calls, a covered put option strategy involves issuing puts (sale options) while holding a short selling position equivalent to the number of corresponding shares held. Pursuing further, the investor shorts the securities that he then covers by selling the corresponding puts, with one of the advantages of such a strategy being the generation of income. This is the reason why the fund can deliver such a high dividend yield, namely 9.14%, and make payments on a quarterly basis. For this matter, as shown in the top ten issuers listed above, QQQX holds stocks that pay dividends.
On the other hand, the main disadvantage of this strategy is that it has limited upside potential if the stock price drops sharply. In this respect, the 20% drop in the introductory chart shows that this has been the case. Furthermore, the high dividend yields show that the fund managers have opted for a strategy prioritizing regular income.
As for the Pacer ETF, it makes use of a completely different strategy.
PTNQ, with its T-Bills Aims for Capital Preservation
PTNQ tracks the Pacer NASDAQ-100 Trendpilot index, with an aim of participating in the market while things are good and backing out when things get nasty. Going deeper, when the NASDAQ-100 Total Return Index closes above its 200-day SMA (simple moving average) for five consecutive business days, which denotes a bullish instance for tech stocks, PTNQ is fully (100%) exposed to the NASDAQ-100 index.
On the other hand, when the inverse happens, or the NASDAQ-100 Total Return Index closes below its 200-day SMA, for 5 days, this signifies a bearish instance for tech. At this moment, the composition of PTNQ changes to 50/50, or 50% is allotted to the NASDAQ-100 index and 50% to 3-months U.S Treasury bills.
In between these two positions, the index also uses the 50/50 and T-Bill indicators as shown in the figure above.
This may seem a bit complicated, but, as shown in the introductory chart, this strategy clearly works as despite holding tech companies forming part of the NASDAQ-100, PTNQ has shielded investors against volatility to a higher degree. Thus, it has suffered from a 10% downside during the last year compared to 22% for QQQ and 13% for the S&P 500.
Comparing with QQQ in Mind
Thus, both PTNQ and QQQX provide exposure to stocks from the Nasdaq 100 while their respective managers also aim to shield against volatility, with the Nuveen ETF also prioritizing income.
Now, with time, U.S. large caps have become the benchmark for the technology sector as they represent innovation and growth while at the same time generating stable cash flows. However, in a market that has been used to cheap money for more than ten years, the filtering out of liquidity from the system by the Fed is causing uncertainty. In these conditions, unless you have a portfolio including treasuries in addition to stocks and are willing to make rapid changes to it depending on market sentiment, it becomes useful to own PTNQ, but, it does not pay dividends as it is primarily focused on capital preservation.
For income, it is preferable to own QQQX, which holds about 60% of combined big tech, communications, and healthcare companies, and it has grown yields at a faster pace than QQQ itself, but also charges higher fees of 0.9% as shown below.
However, as shown by its one-year total return which is only 2% above QQQ, it is highly debatable whether QQQX has been able to achieve its aim of delivering an “attractive total return with less volatility than the Nasdaq 100 Index”. Also, its three-year total returns show that it has fared worse than QQQ despite paying higher yields. For investors, as I mentioned earlier, total returns include dividend payments in case these are reinvested.
Therefore, it is better to avoid QQQX, unless the objective is to obtain income.
Moreover, as shown in the above table, investors who have remained faithful to the mighty Invesco ETF during the last three years, have seen their capital appreciate by above 50%. This period also included the Covid market crash of Spring 2020 which was rapidly overcome with the Fed loosening monetary policy, but, it is unlikely for the years ahead to be the same. In fact, things are likely to be far different with the U.S. central bank’s intent to pursue hiking the federal funds rate until it reaches 4.6% sometime in 2023. The last time this happened was in December 2007, with this month coinciding with the start of the Great Financial Crisis which ended in 2009.
In these circumstances, those who want to profit from the dip in anticipation that the Fed Chairman may blink (switch to a more dovish position) in case the CPI (consumer price index) stabilizes from its August high or recession fears take precedence over inflationary concerns, may opt for PTNQ. Based on momentum indicators, PTNQ could fall to the $49.70 level, constituting an opportunity to buy, but, in case, there is any news pertaining to a liquidity crunch, the share price may fall further.
In this respect, the Pacer ETF has delivered a better degree of capital preservation than QQQX when considering the total returns, despite the higher dividend yields paid by the Nuveen ETF.
Finally, this thesis is not for those who want to stay in cash and plan to wait for lower valuations to enter the market by investing in QQQ, but rather addresses the need of those who, inspired by Cathie Wood, want to position themselves, but, at the same time want to opt for a less risky approach.