QQQI: Collect High Yield from Technology Through Covered Calls (NASDAQ:QQQI)

summary

Covered call ETFs have been a great way to supplement any amount of income that may be produced from your portfolio of holdings. In my case, I have a basket of roughly 50 different traditional dividend stocks, REITs, business development companies, and closely held companies. The money and higher distribution yields raised from hedged ETFs will likely flow into other areas of my portfolio. However, there are a large number of hedged ETFs that are experiencing continued price deterioration. NEOS NASDAQ-100(R) High Income ETF (Nasdaq: QQQI) is a new ETF on the block with an inception date of January 2024. Since it’s new, I wanted to take a fair look at QQQI to see if it would suffer the same price fate as similar covered ETFs like the Global X Nasdaq 100 covered call ETF (QYLD).

QQQI’s goal is to distribute high monthly income generated by its holdings that closely matches the Nasdaq-100 Index. The fund generates this income through a data-focused call option strategy. What makes QQQI different is that its options strategy may include bought and sold Nasdaq-100 options which actually offers the possibility of capturing the upward price movement of the underlying stock. This is because QQQI uses an out-of-the-money option strategy which allows the upside of the price to be captured, compared to an at-the-money strategy which does not. QQQI has a strong expense ratio of just 0.68%.

The current distribution yield exceeds 14.5%, making it a very attractive fund for investors looking to add high levels of income to their portfolio. Better yet, distributions are issued on a monthly basis, which can be best used by investors who are approaching or in the retirement phase of their investment journey. This high level of income can be used in many ways, but it also comes with some pitfalls, such as the high capital upside that is identified due to the option strategy.

Strategy and weaknesses

The fund’s strategy is to align its holdings with the Nasdaq 100. This means that QQQI is heavily tilted toward the technology sector. The fund aims to invest at least 80% of its assets and collect the profits and interest received for distribution to shareholders. However, the technology sector is not typically known for its large dividend yields, so QQQI implements an “out of the money” option strategy to help generate the additional income needed.

Implementing an “out of the money” strategy is more efficient in my opinion because it helps in getting more upside compared to an “at the money” strategy. OTM strategies have strike prices that are higher than the current market price of the underlying stock or asset. This means that he has more room for the underlying asset to rise in value before the options are actually exercised. Conversely, an ATM strategy means that the strike price is close to the current market price and does not have the same opportunity for an upward move.

OTM option strategies may have a lower distribution since these tend to have lower premium amounts to collect. However, I personally feel that this is a good trade-off if it means a better level of risk and less price deterioration over long periods of time. ATM options strategies in general may have higher and more consistent returns, but these price charts look scary to me. Take a look at the chart of QYLD, which implements the ATM option strategy. I covered the risks of ATM ETFs in my recent coverage of QYLD.

Despite better use of OTM call options, the strategy still suffers from some price weakness. The upside of the price is mainly determined by this strategy, and the QQQI will likely not capture any further upside. This is because once the price reaches the strike price, the option is exercised and no further upside is seen. However, you may still capture all of the downside risks associated with price movements of the underlying assets. So, if the tech sector sees a big sell-off, QQQI will likely see a lot of that downside as well.

So, if you’re looking for a high-yielding asset class that can also provide a higher sense of capital appreciation, I don’t think QQQI might be for you. You must be okay with the fact that you are trading the possibility of capital appreciation in the future for higher income now. With this in mind, let’s take a look at the holdings within QQQI.

Collectibles

QQQI remains diversified with exposure to various industries. However, the technology sector represents about 51% of the exposure, which makes sense since the ETF aims to replicate the Nasdaq 100 (NDX). This is followed by the second largest sector in the telecommunications sector, which represents 16%. Consumer cyclical stocks are the only remaining sector that represents a significant slice of exposure, with a weight of about 12%.

Additionally, we see a lot of top tier holdings as part of the top 10 by weight percentage. We can see that Microsoft (MSFT) is the largest holding, making up about 8.5% of total assets. Followed by Apple (AAPL) with 7.75% and NVIDIA (NVDA) with 6.25%. This majority weighting toward the technology sector actually helps create higher distribution income, even though these holdings have little to no dividend yields. This is because the option strategy takes advantage of higher levels of volatility, which is typically seen in technology stocks.

When volatility increases, the potential for greater price fluctuations in that individual property increases. For example, Nvidia has been one of the most volatile companies so far in 2024 and has seen significant price growth. High volatility like this creates the opportunity to charge higher option premiums, as buyers are willing to pay more for the price protection that options provide. Additionally, covered ETFs like QQQI are a great way to offset the risk of these highly volatile assets by providing a significant stream of distribution income.

Dividend

As of the last declared monthly dividend of $0.6129 per share, the current dividend yield is approximately 14.5%. Since QQQI’s history is so short, we don’t have a lot of historical data yet to base any predictions on. However, it is safe to assume that distributions may change from month to month as they are fed directly from the fund’s performance. Taking a look at history, the dividend has stayed within a pretty consistent range so far, ranging between $0.58 and $0.6129 per share.

The noteworthy thing about the distribution received here is that it consists mostly of a return of capital. Typically, return of capital is viewed as a negative when it comes to closed-end fund distributions because it means the fund is funding the distributions with investors’ own capital. However, with a covered call fund like the QQQI, this is merely a tax classification as a result of the income generated from the options within it.

We can see that year-to-date distributions are also slightly funded by net investment income, which includes dividends and interest earned by holding the underlying assets. The majority use of return of capital has its own advantage here, because this means that the income received is more tax-friendly.

This means that ETFs like QQQI can be used in both tax-advantaged accounts as well as regular taxable brokerage accounts. However, you may still incur tax consequences resulting from capital gains during the time of sale.

Prospects

Since all ETFs tend to thrive in high volatility environments, I wanted to offer some of my thoughts on how I think the fund will perform in the future. With the US presidential election taking place at the end of 2024, I believe this will provide high levels of uncertainty in the markets, which may translate into higher levels of volatility. While this volatility may be good for the income generation side of QQQI, the data also supports the potential for the overall stock market to move after the election is over. Therefore, we have the ability to benefit from increased income as well as some minor upward movement afterwards.

In addition, we have ongoing talks about lowering interest rates. The federal funds rate remains at an all-time high over the past decade, due to the rapid rises that occurred in mid-2022. Inflation is starting to show signs of slowing and unemployment currently remains low. . I think we are likely to see very small interest rate cuts by the end of the year, and this is in line with many economists’ forecasts, who expect there to be a cut as early as September 2024.

I believe interest rate cuts will push market valuations higher. This is because as interest rates fall, debt equity financing becomes easier to obtain through lower debt maintenance costs. As a result, many companies across all sectors are able to pursue more growth initiatives that can fuel higher price movements. This includes a greater amount of capital spending, additional research and development, acquisitions and expansion opportunities.

Finally, keep in mind that the Fed either cuts or raises interest rates during most election years. While previous decisions have no impact on this year’s decision, it serves as a nice reference point that the Fed has historically made interest rate changes more frequently during election years than it has not. It is worth noting that any interest rate talks have historically caused higher levels of volatility in the markets, which are prerequisites for QQQI to generate higher income.

Away

In conclusion, QQQI’s covered call option strategy offers the opportunity to collect a high dividend yield of 14%. Additionally, QQQI uses an out-of-the-money option strategy, which allows ETFs to capture some of the upward price movements during bull markets. This is a nice bonus compared to the negative price degradation that can be seen with covered ETFs that use at-the-money option strategies. QQQI remains highly diversified but leans more towards the technology sector.

While this may present some concentration risk, it is likely offset by the fact that the technology sector typically faces a higher level of volatility, which could benefit QQQI. With the US presidential election approaching and ongoing interest rate talks, I believe market uncertainty will be high, causing the QQQI distribution rate to continue.