QYLD has been gaining popularity among income investors as a bullish-yet-defensive play on the NASDAQ 100. Here we’ll review it and look at why it’s probably not a great choice for a long-term buy-and-hold portfolio.
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Introduction – What Is QYLD and How Does It Work?
QYLD is an ETF from Global X that holds the NASDAQ 100 index and also sells covered calls on it to generate income. To my knowledge, it is the largest covered call strategy fund with over $3 billion in assets.
As a brief refresher, covered call writers own the underlying and collect a premium on the option, and the buyer of the call option has the right to buy the underlying at the strike price at or before expiration. For example, if I own a fund like QQQ for the NASDAQ 100 and I think it’s going to be relatively flat for the next 30 days or so, I might sell a call option on it, for which I receive cash immediately (called the premium). The buyer of that call option is hoping QQQ goes up. As the seller, I’m hoping it stays flat. Call options are usually sold to generate income in a flat or mild bear market.
This is exactly what QYLD does. The fund holds stocks in the NASDAQ 100 and writes 1-month at-the-money calls on them. It’s pretty simple; nothing proprietary going on. QYLD charges a fairly hefty 0.60% for this strategy. QYLD is popular because this allows the fund to have a distribution yield upwards of 10% that pays monthly, making it attractive to income investors.
Is QYLD a Good Investment? Probably Not.
While QYLD uses the NASDAQ 100, Global X also offers RYLD for the Russell 2000 (U.S. small- and mid-caps) and XYLD for the S&P 500 (U.S. large caps). All 3 funds work the same way.
These funds seem to be popular among income investors and FIRE folks, but I have yet to see a compelling reason for investors’ fascination with these funds. I have to assume most simply aren’t looking past the extremely high yield and perhaps don’t know what they’re buying. There’s even an entire community on Reddit dedicated to this thing.
Inexperienced investors seem to have this idea that the “income” and dividends from these expensive funds are free money, or that selling shares of a low-cost index fund like VTI – or even QQQ in this case – to realize gains of an equal amount is somehow inferior to receiving a dividend. Neither of these things is true. This irrational preference of dividends as income is just a well-documented – and admittedly understandable – mental accounting fallacy. Again, I suspect investors unfortunately aren’t looking too far past the high yield carrot of these funds before buying in.
First, specific to QYLD, the NASDAQ 100 is poorly diversified and is basically a tech index at this point. It is purely large cap growth stocks. Investors have been chasing recent performance by flocking to NASDAQ 100 funds like QQQ and QQQM simply because the index has beaten the market over the past decade, thanks largely to Big Tech.
But the market itself is already over 1/4 tech, and large cap growth stocks are looking extremely expensive relative to history (and relative to Value). Moreover, the valuation spread between Value and Growth is as large as it’s ever been. Because of all this, we’ve got concentration risk and lower future expected returns for large cap growth stocks. Only time will tell, but now may actually be the worst time to buy Growth and the best time to buy Value. Large value spreads have historically preceded its marked outperformance. Alas, all crystal balls are cloudy, but I’d argue that’s precisely a good reason not to be concentrated in the NASDAQ 100 Index.
Secondly, dividends/distributions aren’t free money. Because part of QYLD’s assets come from its option selling, its total return is muted, making novice investors feel like it’s safe. But this is the wrong way to think about it. Removing its distributions, QYLD’s capital appreciation component is virtually flat on average and has actually been negative since inception:
QYLD vs. QQQ
At this point, since we’re talking about dividends and price appreciation, let’s pause the discussion for a second to look at QYLD vs. QQQ in terms of sheer performance. Recall that QQQ is just the plain ol’ fund that tracks the NASDAQ 100 Index.
The backtest below will hopefully be eye-opening. Even with QYLD’s dividends reinvested, the underlying QQQ has delivered a greater risk-adjusted (and general) return since QYLD’s inception in late 2013:
Some quick important takeaways:
- QQQ still delivered a significantly greater risk-adjusted return (Sharpe; ratio of return to volatility) even though it was about 50% more volatile than QYLD. Covered call strategists boast about their greater Sharpe ratios, but the argument doesn’t even hold water here against the underlying QQQ. The Sortino ratio arguably illustrates this even better, as it only looks at downside risk. QQQ’s Sortino ratio was over twice that of QYLD.
- More importantly, notice the nearly identical max drawdowns. Simply put, QYLD does not protect the downside. I’ll explain this in a second. QQQ had a Calmar ratio (ratio of return to max drawdown) of over 3x that of QYLD as well.
- Similarly, QYLD doesn’t get to fully participate in the upside. Notice how the “best year” return for QQQ was more than double that of QYLD. I’ll explain this later, too.
I usually say backtests don’t mean much (i.e. they have little to no bearing on the future), but out of all the ones I’ve posted on this website, this one is arguably the most telling, the most straightforward, and the most useful for one’s future strategy. If it doesn’t illustrate why this fund is pretty awful, I don’t know what will. What’s more, all this poor performance of QYLD comes at 4x the price of its underlying index.
I’ll resume the discussion and continue explaining the details in the following section.
Continuing the Discussion – More Reasons QYLD Stinks
I can easily think of 2 other portfolios off the top of my head that are safer, cheaper, more diversified, more tax-efficient, and that have had much higher general and risk-adjusted returns, lower volatility, lower excess kurtosis, and smaller drawdowns than QYLD. If one wants a high dividend yield to use as income, I’d think you could think of combinations of dividend funds, high yield corporate bond funds, etc. that would be objectively superior to QYLD in almost every way, such as Portfolio 3 in the backtest I linked. You’d likely even come out ahead after taxes with high-div REITs considering QYLD’s high fee. Moreover, its return has even severely lagged income-focused CEF’s. I designed a dividend portfolio for income investors here that may appeal to you.
The situation for QYLD is exacerbated in a taxable environment because you’re taxed on any taxable distributions, regardless of whether or not you reinvest them. Thankfully, some of QYLD’s distributions may be classified as a return of capital, meaning no taxes (until your cost basis is zero), and most of them have indeed been ROC in recent years for QYLD, but this hasn’t always been the case during the fund’s lifespan, so that preferable tax treatment is by no means guaranteed. Look at 2016, when the fund’s ROC was only about 27% and short-term capital gains distributions were about 51%. This was also a wake-up call for many in early 2022, when Global X announced that 100% of QYLD’s distributions for 2021 would be classified as – and thus taxed as – ordinary income, not as ROC. Ouch.
I’m a fan of simply selling shares as needed for any “income” needed, which should be mathematically preferable anyway if you don’t actually need that income on a monthly basis, as it allows you to leave more money in the market longer.
Thirdly, covered calls cap the upside at the strike price. They’re not a free lunch. If the underlying rallies, you don’t get to fully participate. Aren’t we investing in the market – in any form – because we expect it to go up more than it goes down? Even if income is the goal, why would we want to purposefully stifle the portfolio’s growth? This concept is illustrated in the backtest above by the “best year” returns.
In total fairness to QYLD, a covered call fund would be nice in a totally flat market, as you’d just float along collecting the premium from writing call options when the underlying isn’t doing anything. Granted, the premium would be lower, but you’d be better off than if you were only holding the underlying index that was just moseying along decaying. But we don’t see that market environment very often (and we wouldn’t expect to), and for the rest of the time leading up to and following that flat period, you’d be underperforming. This type of flat market is even less likely with the Nasdaq-100, which is actually good in terms of the premium received.
Lastly and arguably most importantly, covered calls don’t protect the downside. This is probably the one I see QYLD proponents erroneously trying to push most often. In fairness, they simply may not understand how covered calls work. Don’t succumb to mental accounting bias; the premium received doesn’t mean much if the market crashes. If the underlying drops, so does the fund, along with its distribution yield. Again, you don’t have to take my word for it; just look at the clear illustration in the backtest above of the nearly identical drawdowns. Another covered call fund, NUSI, does offer downside protection by buying a protective put option.
I see comments all the time about QYLD being “safe” or that it offers “downside protection.” Neither of these things is true. Global X themselves even claim in the fund literature that “covered call strategies can play a useful role in a portfolio during downturns,” but they sort of gloss over the fact that the drawdowns are typically lower by the precise amount of the option premium received; that cash doesn’t really offer any “protection.” Returns from covered call funds like this are asymmetrical, and we would expect them to be – severely capped upside, but nearly the same downside as the underlying index. In statistical terms, this is called negative skewness of returns, and investors typically try to avoid it.
So we’re purposefully limiting the upside potential while leaving unlimited downside risk, all in the name of “income.” Intuitively, this should at least strike you as suboptimal.
I personally don’t think QYLD’s 12% yield is sustainable anyway. So far the fund hasn’t had to endure a major crash like 2008 or 2000, or arguably worse, a protracted bear market. Market conditions (a raging bull market for the most part, particularly for Big Tech) have been ideal for these funds in their relatively short lifespans thus far.
In terms of downside protection, there’s an objectively better, simpler, cheaper, more tax-efficient solution that existed long before these funds came about: decrease stocks and add bonds. And for those who are holding QYLD because they think bonds suck, consider checking out my brief rant on why bonds are still useful in basically any environment. We’d also want to be more diversified across assets and geographies in general. In short, as the backtest above showed, covered calls are not an efficient way to lower the volatility and drawdowns of a portfolio.
And again, all these undesirable characteristics come at 4x the price of the underlying index.
Suppose you still hate bonds. You can use T-bills, which are literally called the “risk-free asset” and are considered a cash equivalent. They also happen to be a decent inflation hedge because they can be rolled quickly. Let’s take the simplest example of a naively-weighted 50% NASDAQ-100 and 50% cash (T-bills) to once again show how one can easily beat QYLD in a simpler, cheaper, more tax-efficient manner:
Notice how we’ve once again beaten QYLD on every single metric – higher return, lower volatility, more upside captured (best year), lower volatility, much smaller drawdown, and much higher risk-adjusted return.
The only appropriate scenario I can see for buying these types of funds is if the investor, for some reason, consciously wants to implement a rolling covered call strategy without handling the logistics of writing the options themselves, in order to generate regular income (from the option writing) that they need every month. Let me put this very simply and straightforwardly. If you do not need that regular income every single month to pay for your expenses, there is no reason for you to buy funds like these. More generally, I’d even say if you are reinvesting its dividends, there is no reason for you to buy funds like these.
But if income is the concern, I’d say just go with CEF’s, or again, a combination of dividend stocks and high-yield bonds. “Income” is overrated anyway. I’d be more likely to go with something like SWAN or SPD and just set up an automatic monthly transfer from the brokerage account that sells shares for me; there’s my “income.” In the interest of full disclosure, I’m not a dividend investor anyway, and I’d rather just sell shares as needed, so these types of yield-focused strategies don’t appeal to me regardless. I’d rather create my own dividend when I want to. But after looking at the objective facts, I still can’t understand why anyone would buy these funds.
Again, we can construct a demonstrably superior strategy with even the simplest, naive mix of 50% NASDAQ-100 and 50% T-bills. I’ve created that pie for M1 Finance here if you’re interested. I wrote a comprehensive review of M1 and why it’s great for income investors here.
Ironically, if I were forced to use these funds, I’d certainly go with the greater diversification of XYLD with a dash of RYLD to get exposure to the entire U.S. market instead of the more popular QYLD that narrows in on the NASDAQ 100. Investors have gravitated toward the latter due to recency bias and performance chasing. This is both irrational and hypocritical, as they’re simultaneously citing QYLD’s “safety” and “protection.” One will inarguably get comparatively more of those things with the broader index that XYLD uses (the S&P 500). Some are buying QYLD on margin, which doesn’t make much sense to me. Others are even using QYLD as a savings account “replacement” and are reinvesting the dividends, which is nonsensical.
There’s no free lunch outside of diversification. If you are reducing risk with expensive option hedging strategies, you are by definition also accepting lower expected returns. But as we’ve seen, QYLD doesn’t even do a good job of that. Again, covered calls are simply not an efficient way to de-risk a portfolio.
In fairness, with bonds entering a headwind and stock valuations at all time highs, options strategies may indeed prove fruitful going forward for some unknown time period for the income investor with a short time horizon; but I’d still submit that it’s highly unlikely we’d see a flat market over the long term, and I’d still prefer something with downside protection like NUSI. Only time will tell. Covered call funds are also not the worst strategy I’ve seen to try to generate income.
Disclaimer: While I love diving into investing-related data and playing around with backtests, I am in no way a certified expert. I have no formal financial education. I am not a financial advisor, portfolio manager, or accountant. This is not financial advice, investing advice, or tax advice. The information on this website is for informational and recreational purposes only. Investment products discussed (ETFs, mutual funds, etc.) are for illustrative purposes only. It is not a recommendation to buy, sell, or otherwise transact in any of the products mentioned. Do your own due diligence. Past performance does not guarantee future returns. Read my lengthier disclaimer here.
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