Dividend Growth Stock of the Month for October 2021: 11.5% Yield

This month’s Dividend Growth Stock is not a stock. It is an ETF (Exchange-Traded Fund).

And as we will see, it’s not a dividend-growth fund either. But it may be worthy as a dividend-growth investment, because it yields more than 10%.

Confused? Don’t worry, all will be explained. Welcome to this special edition of my monthly series on great dividend-growth stocks investments.

ETFs in Dividend Growth Investing

I believe that one can follow a reasonable DG strategy via ETFs. I think that a portion of any DG portfolio can be comprised of dividend-growth ETFs in addition to individual stocks.

We all know by now that there are three reasons that the dividends from a dividend-growth portfolio grow over time:

(1) The companies themselves raise their dividends.

(2) We can manage our portfolio to increase its yield or dividend-growth rate.

(3) We can reinvest dividends to buy more shares that generate new dividends.

What if we own a stock or a fund that is not a dividend-growth fund? The first method is gone: The investment doesn’t raise its dividends. And the second method may apply or not depending on circumstances.

But the third method – reinvesting dividends – certainly applies. In fact, the higher the yield of the stock or fund, the more dividends there are to reinvest. Which brings us to our fund this month: QYLD, whose formal name is NASDAQ-100 Covered Call ETF. This is an ETF offered by a company called Global X, which offers many products of this type.

I read recently that if you are looking for high yield in today’s markets, one of the first things to consider is funds that are based on selling covered calls. These funds hold a basket of stocks and then sell call options against those stocks. The premiums on the options generate high income.

That’s what QYLD does. It’s an ETF that came to my attention from comments that I got on my May video on dividend-growth ETFs.

QYLD is not a dividend-growth ETF. Most of its assets do not even pay dividends. Rather, as we will see, QYLD generates income by selling call options against its stocks.

QYLD is one of a growing number of ETFs that might be called “new wave.” In the early years of ETFs (the 1990s), most ETFs were based on simply holding well-established stock baskets like the S&P 500, Dow Jones Industrial Average, and similar venerable indexes.

That meant that early ETFs were relatively passive investments. The investor simply bought shares of the ETF, and the ETF, in turn, held the stocks of a slowly-changing index.

Nowadays, however, many indexes are created for the purpose of marketing ETFs based upon them. These are not the staid indexes of yore. In fact, some of them can be quite active. These are not your father’s ETFs.

Covered-Call ETFs

The index on which QYLD is based is not an old-fashioned list of stocks passively held.

QYLD is based on a covered call index, meaning that it generates returns by trading options according to the specifications in the index it follows. An investor cannot hold an index directly. An index is more like an academic paper. An index holds no stocks. Its portfolio is hypothetical, and it ignores the fees and expenses that would be involved in actually buying the stocks and doing the trading that the index suggests.

That’s where ETFs come in. They buy the actual stocks and options specified in the index, charge for their work, and thus become real investments that we can buy.

The primary purpose of a covered-call strategy is to generate income. Call options are financial instruments that give the call buyers the right to buy a stock from their counter-party (the seller or writer of the option) at an agreed-upon price and date. The agreed price is called the strike price.

When a covered-call writer (QYLD in our case) sells a call option, it earns an immediate premium. It keeps that premium no matter the outcome of the option. If the strike price is reached by the stock, the buyer of the option will call away the stock, because they can get it cheaper from the option-writer than from the open market.

So, selling call options is a way to generate income based on the risk that a stock will be called away. Therefore, price volatility is the biggest total-return risk in a covered-call strategy. Volatility makes it more likely that the call option will be exercised, because it makes it more likely that the strike price is hit. And since markets tend to rise over time, calls written near the current price of the stock (which is QYLD’s practice) will tend to be called away more often than not.

Usually when you hold an ETF, you are said to own the stocks in the fund. That is true, but notice that there is an important caveat with a covered-call fund. From the call-writer’s point of view, a risk of selling options is that potential profits from the rising prices of the stocks in the portfolio will not accrue to your benefit. Once the stock’s price passes the strike price, further price increases go to the option buyer. As Global X says, “Covered call strategies inherently forfeit upside in exchange for current income.” (Source)

And beyond that, the ETF’s holders are exposed to all of the price downside that may occur, because the stocks are not called away.

Many call options expire without hitting the strike price, in which case the writer keeps both the stock and the premium.

The ideal scenario for a covered-call writer (QYLD in our case) is for the stock price to stay under the strike price for the duration of the option contract, without going down very far. That way, the option writer keeps both the premium and the shares, and does not lose money to price declines in the shares.

In researching this article, I was surprised to learn that covered-call ETFs are a “thing.” There are about 20 of them. Such ETFs are currently quite popular, accounting for all five of the top ETFs in 30-day net investor inflows according to data accessed on September 28, with QYLD at the very top of the list. Four of the five are Global X products.

(Source)

QYLD in a Nutshell

The NASDAQ-100 Covered Call ETF (QYLD) was launched on December 11, 2013. It has become a very popular fund among retail investors. QYLD is the largest covered-call ETF, with $4.5 B in assets. That’s about two-thirds the combined value of all 20 covered-call ETFs.

QYLD pays a monthly dividend (or distribution) from the income generated by selling call options against the NASDAQ-100 index.

Therefore, QYLD offers investors a simple way to participate in a covered-call income strategy based on securities in the NASDAQ-100. The investor just owns QYLD. The ETF takes care of everything else.

The big attraction is the income return: QYLD provided investors a gross distribution yield of just over 12% over the past 12 months.

A secondary attraction is QYLD’s monthly distributions. Some investors like monthly payouts. (Personally, I don’t care if dividends come to me quarterly or monthly.)

QYLD’s Operations

The index followed by QYLD is the CBOE NASDAQ-100 Buy-Write Index. “Buy-Write” means the same thing as “covered call.” The seller of the option buys the stocks first, then they write options to sell them.

Here is how Global X illustrates how QYLD works. First, in a down market, QYLD will generally benefit from the premium it receives, because the month will end with the index (against which the calls are sold) below the strike price, so QYLD keeps both the stocks and the premium. The premium will offset some (or even all) of the decline in the index’s price.

In a flat market, the calls are not exercised either, so again QYLD keeps both the premium and the stocks.

A rising market, however, brings the risk of selling covered calls into play. If the index price rises by the end of the month, above the strike price, QYLD still keeps the option premium, but it won’t benefit from the increase in the index’s value.

Here is how Global X diagrams its operations. It does this every month:

(Source)

Notice that the diagram states that QYLD distributes “a portion” of the income from writing the calls to QYLD’s shareholders. To be more specific, Global X states elsewhere that “[T]he fund expects to distribute on a monthly basis one-half of the premiums received by writing calls on the Nasdaq 100, capped at 1% of the Fund’s net asset value (NAV). (Source)

In words:

  • QYLD buys all the stocks in the NASDAQ-100 index.
  • QYLD sells call options against the index itself (not the individual stocks).
  • The options are priced at or slightly above the index’s value at the time of writing the options.
  • The options are one-month in duration. New ones are written monthly, which provides the monthly cash flow stream to QYLD’s investors.
  • QYLD targets approximately 1% per month in distributions.
  • Importantly, price changes in the index during the month do not matter if they exceed the strike price. The type of options sold cannot be exercised early, so all that matters is the price of the index at the end of the month.

The options are settled in cash; no shares of stock or of the index change hands. The cash settlement amount is determined from relation between the value of the index and the strike price.

So, QYLD’s covered calls may partially protect it from a decline in the price of the index via the premiums collected for the options. However, if the stock market is rallying, QYLD will underperform the index, because the calls prevent QYLD from participating in the index’s rising price above the strike price. And the option premiums may not be sufficient to offset losses or underperformance of the strategy over time.

The magnitude of risk from not participating in price rises during a market rally is related to the percentage of stocks against which calls are written. Since QYLD sells options on the entire NASDAQ-100, it is effectively optioning 100% of the stocks that it owns. That means that it maximizes the risk of underperforming the index, but also that it generates the maximum income for its shareholders from the premiums that it collects from selling the calls.

Now let’s take a look at the two indexes that determine QYLD’s performance: (1) The NASDAQ-100 index of stocks, and (2) the buy-write index that determines how and when covered calls are written against the index of stocks.

The Stock Index: NASDAQ-100

NASDAQ – which originally stood for National Association of Securities Dealers Automated Quotation system – is now written as an ordinary name rather than an acronym. It’s a stock market, launched in 1971, that offered the first all-electronic system for trading stocks.

The NASDAQ-100 index is a selection of the largest, most active companies traded on NASDAQ. It excludes financial companies, and its stocks are weighted in a certain way that you do not need to understand for QYLD’s purposes.

As we said earlier, you can’t own an index, because it is a theoretical construct. But you can own an index through an ETF that replicates it in real life. The NASDAQ-100 can be owned and traded through Invesco’s QQQ Trust (QQQ) ETF.

The NASDAQ-100 is dominated by tech stocks. Here (per Morningstar) are the top 10 holdings in the index. They are all tech or tech-like companies. These top-10 companies account for 53% of the index.

The next display shows that the NASDAQ-100 holds high-quality companies as measured by Morningstar’s moat rating. Per the table, 57% of the fund’s assets have wide-moat ratings and another 37% have narrow-moat ratings. Other Morningstar grades are high as well.

The next display shows the overall distribution of the index’s stocks by sector.

(Source)

The three largest sectors – Information Technology, Communication Services, and Consumer Discretionary – account for 85% of the index. Note also that Amazon and Tesla are in the Consumer Discretionary sector, even though many (if not most) investors think of them as tech stocks.

Because of this concentration in holdings, QYLD is classified as a “non-diversified” investment company under the Investment Company Act of 1940. In practical terms, the fund is prone to be more volatile than a more-diversified fund would be.

The Strategy Index: CBOE NASDAQ-100 Buy-Write Index

The CBOE NASDAQ-100 BuyWrite Index (“BXN”) is a benchmark index that measures the performance of a theoretical portfolio that holds the stocks in the NASDAQ-100 and writes (sells) a succession of one-month covered call options against the index.

QYLD replicates BXN’s processes, which we already covered above.

Despite the fact that most investors buy QYLD for its monthly income, the underlying CBOE index is really a total-return strategy. QYLD has simply redeployed the buy-write mechanism to distribute cash to shareholders rather than reinvest it into the Nasdaq-100 index (or its component stocks).

QYLD’s Performance vs. Its Objectives

According to its home page, these are QYLD’s objectives:

(1) High income potential. QYLD seeks to generate income through covered call writing.

(2) Monthly distributions. QYLD is designed to make monthly distributions rather than quarterly.

(3) Efficient options execution. QYLD writes and manages the call options, saving investors the time and potential expense of doing so individually.

Note that QYLD does not list total return as one of its three purposes. Of course, total returns are very important to many investors, so we will look at them later. Here, we’ll just focus on QYLD’s three stated objectives.

(1) High income potential

QYLD has hit its goal of high potential income in spades. This chart shows its yield since 2015. It has spent most of its time in the 9-12% range. Right now its current yield is around 11.5%.

At 10% average yield, an investor in QYLD would make back their entire initial investment in 10 years. At 11% average yield, the payback period falls to 9 years.

(2) Monthly distributions

This chart shows QYLD’s dividends since inception. Other than a couple skipped months early in its life, QYLD, has paid monthly dividends since inception in 2014.

As with all ETF’s, QYLD’s dividends vary from payment to payment. Just eyeballing a trend line, it looks like QYLD’s monthly payment has averaged about $0.15-0.20 per share per month since inception.

(3) Efficient options execution

QYLD is designed for an investor like me, who wants equity income but does not want the labor of trading options to get it. I don’t want to be tied to my computer that much. QYLD charges 0.60% in fees to do it for me.

Overall, it’s fair to say that QYLD has hit its three objectives since it was released:

  • High income
  • Monthly payments
  • Efficient execution of covered-call operation

QYLD’s Total Return Performance

Even income investors don’t like to lose capital while they are generating income. Therefore, let’s examine QYLD’s total returns.

We know from earlier discussion that a covered-call strategy sacrifices total return in exchange for high yield. With that in mind, what is “good” total return for an investment that’s generating 12% per year in income?

QYLD presents an interesting case, because it goes all-in on the covered-call strategy. We saw earlier that applying that strategy to 100% of a portfolio’s stocks maximizes the likely damage to total returns. So clearly, one would employ this strategy if one is striving for very high yields, knowing the trade-offs. Just from its design and descriptive literature, QYLD does not present itself as a buy-and-hold investment designed to amass wealth. It does present itself as a source of reliable high yields that are paid monthly.

Keeping that in mind, here are four total-return comparisons that you might find useful.

(1) S&P 500

Here are QYLD’s price returns – without dividends or dividend reinvestment – compared to SPDR S&P 500 ETF Trust (SPY), an ETF that tracks the S&P 500. The timeframe starts at the beginning of 2014, which is just after QYLD was commenced.

Remember, this shows changes only in price. SPY pays a dividend of only 1.3% in contrast to QYLD’s dividend of 11.5%.

You can see that QYLD’s price-only returns are negative in the nearly eight years of its existence. That may be surprising, given that the underlying stocks it owns are dominated by the red-hot technology sector. But they are not surprising when considering how a covered-call strategy limits upward price rewards.

In all of the comparisons, QYLD’s negative price-only returns have been the worst. QYLD is designed to be a dividend-generating machine, and price-only comparisons ignore that income. So let’s account for those dividends by displaying total returns with dividends reinvested (i.e., dripping the dividends back into buying more shares).

Even taking dividends and reinvestment into account, we can see that QYLD’s total returns have only achieved about half of simply holding the S&P 500 itself via SPY.

Of course, if you did that and needed income, you would have to sell shares of SPY every month to turn some of your paper gains into cash. That works fine when prices are going up; it can be uncomfortable when prices are going down.

(2) Covered-call ETF for S&P 500

Global-X offers a covered-call ETF where the stock index is the S&P 500. This ETF – Global-X S&P 500 Covered Call ETF (XYLD) – is attracting a lot of money from investors. It has a current yield of about 6.3%.

Here is the total-return comparison with dividends reinvested:

XYLD has achieved about 80% of the total returns of the S&P 500. Note also that XYLD’s total return (75%) is less than QYLD’s total return (94%) shown earlier over the same time period.

(3) QQQ itself

Since QYLD uses the NASDAQ-100 as its stock portfolio, it’s fair to ask how QYLD’s returns compare to Invesco QQQ Trust (QQQ), the ETF that tracks that same portfolio without embellishments. QQQ’s current yield is about 0.5%.

Here’s the total return comparison with dividends reinvested:

QYLD, even accounting for dividends and reinvesting them, has barely exceeded ¼ of the total returns of the same index of stocks that it invests in. That is an extreme example of the foregone price returns from applying a covered-call strategy to a portfolio of high-flying stocks. QQQ has been on an almost continuous bull-market run since 2009.

Again, however, remember that to generate income, if you need it, you would need to continually trim QQQ shares and realize the paper gains. Every time you trim, you would reduce future gains, because you would own fewer shares.

(4) Closed-End fund

As I said earlier, I was surprised to discover the proliferation of covered-call ETFs that are available to investors. I usually associate that kind of strategy with closed-end funds (CEFs).

There is not space here to get into how CEFs operate. Suffice it to say, they too are designed to “convert” total returns into income for investors, and some of them use covered-call strategies to do it.

And, lo and behold, one of them uses a covered-call strategy on the NASDAQ-100, just as QYLD does. It is Nuveen NASDAQ 100 Dynamic Overwrite Dividend (QQQX). Quick facts about it:

  • Introduced in 2007
  • Designed to offer regular distributions by replicating the price movements of the NASDAQ 100 Index, as well as selling call options on an average of 55% of the Fund’s equity portfolio. (Remember that applying covered calls to about 50% of a portfolio garners half the premium income but also allows participation in about half the upside of the underlying stocks.)
  • Pays quarterly
  • Current yield = 6.2%
  • Payouts are much smoother

This chart shows QQQX’s payouts since inception.

(Source)

Because QQQX applies the covered-call strategy to about half of its portfolio, we would expect its total returns to be about 2x better than QYLD’s. That’s the payoff for generating about half the yield that QYLD generates. QQQX sells covered calls on about 55% of its holdings, which allows it to participate in more price upside.

As you can see, the Nuveen CEF almost doubles QYLD’s total return performance while yielding about half as much (12% to 6%).

Summarizing Everything

I know this is a long article, so to make everything more understandable, here is a summary of the results:

What are the takeaways?

  1. Total returns tend to be inversely related to yield: Higher yields tend to be associated with lower total returns and vice-versa. If you need income and don’t get much from organic yield, you will need to generate it by selling shares; you need to hope that the pace of positive returns exceeds your pace of selling shares off.
  2. QYLD forfeits a great deal of price return, and therefore of total return, in exchange for the income generated through the covered-call strategy.
  3. That said, QYLD’s income is significant: Figure on 10-12% yield most of the time.
  4. QYLD generates income from a selection of stocks (mostly tech stocks) that normally do not provide much income. Thus, an investment in QYLD could be seen as a way for an income-focused investor to diversify risk by participating in a sector that usually provides little in the way of dividends. However, much of the potential upside of that sector is lost because of the covered-call strategy, so the historical benefit of holding lots of tech stocks is mostly wiped out.
  5. QYLD pays monthly, which some investors will find attractive. The payments can vary significantly month-to-month.

QYLD’s Possible Role in a Dividend Growth Portfolio

Most dividend-growth investors understand that high yields usually accompany slow growth. For example, Verizon (VZ), which is high-yield as dividend-growth stocks go (4.7%) has slow dividend growth (2% per year over the past five years). Its price doesn’t grow very much either.

But high yields have the obvious charm of the copious dividends themselves. That money can be used to reinvest back into the stock or fund that pays it, which turbo-charges portfolio growth by adding more shares even without adding new money. Similarly, one can reinvest that dividend money into other stocks that have high quality, decent yields, better growth rates, and other attractive characteristics.

If one needs the income for living expenses – which may be the case with some retirees – the attractiveness of the high yield expands. In that case, you are not reinvesting the dividends, you are living off them. The concept of “converting” some of the fund’s total return into regular dividends can be very attractive, because you don’t have to sell shares to generate cashflow for living expenses.

It is hard to value an ETF, because of all the moving parts. At the current time, Morningstar values QYLD’s current price as fair, with a valuation ratio of 1.05 (meaning 5% overvalued).

As shown below (purple line), QYLD has generally traded in the $20-25 range for the past several years except for the Covid crash last year. Yield and price are inversely related, so the lower the price you buy QYLD at, the higher the yield (orange line) you’ll get on the purchase.

For a rule of thumb, you might want to limit purchases to when QYLD’s yield is 11% or 11.5% or above. If you were to buy $10,000 worth of QYLD at 11.5% yield, that would produce $1150 in dividend income in a year, assuming the payments stayed relatively steady.

Lastly, most distributions by covered call funds are not qualified dividends under tax law. The tax implications of this sort of income are too complex to cover here, but note that most of QYLD’s income does not qualify for lower tax rates that apply to the dividends from common dividend-growth companies such as JNJ and VZ. That said, it may be “return of capital” that lowers your cost basis and delays taxes until you sell the shares. Global X advises that “Particularly tax-sensitive investors may want to consider holding covered call ETFs in a tax-advantaged account or consult with a tax accountant prior to investing.”

This is not a recommendation to buy, hold, sell, trim, or add to QYLD. Any investment requires your own due diligence. Always be sure to match your stock and fund picks to your personal financial goals.

— Dave Van Knapp

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Source: DividendsAndIncome.com