Thesis
The first step in investing is understanding what you are buying and the risk factors involved. Say you want to buy bonds – you need to understand the difference between treasuries, corporate bonds and junk bonds in order to zone in the sector that is most suitable for your investment style. The same goes for equities. Equities fall in certain large sectoral allocations such as value, blend or growth, each sector with its unique risk and rewards. Layered on top of this initial risk factor selection is the instrument.
The most common form of buying equities is via index ETFs. Index ETFs are usually passive allocators which just replicate what the underlying index does. With the increase in retail investors in the market and the need for yield, many managers have devised new structures that generate high yields via the covered call structure. The instruments used here can be ETFs or CEFs.
First Trust Nasdaq BuyWrite Income ETF (NASDAQ:FTQI) is an ETF which falls in the buy-write category. The fund aims to extract dividends from the Nasdaq via a covered call strategy. In this article we are going to explore the fund’s build, compare it to other peers in the ETF and CEF space, and articulate why we do not believe this is an appropriate tool to use to extract dividend yield from Nasdaq equities.
Fund build – classic buy-write fund structure
Let us start with the objective the exchange traded fund manager puts forward:
The Fund’s investment objective is to provide current income. The Fund will pursue its investment objective by investing primarily in equity securities listed on U.S. exchanges and by utilizing an “option strategy” consisting of writing (selling) U.S. exchange-traded covered call options on the Nasdaq-100 Index. The Fund will employ an option strategy in which it will write U.S. exchange-traded covered call options on the Nasdaq-100 Index in order to seek additional cash flow in the form of premiums on the options. A premium is the income received by an investor who sells an option contract to another party and may be distributed to shareholders on a monthly basis.
The fund holds 189 names as a proxy for the index and then proceeds to overlay index options on top. This is a common structure for both CEFs and ETFs, and has a flavor of active management, since technically the fund can slightly outperform the index if overweight positions are taken on winning tickers.
Via its build the fund does indeed achieve a high dividend yield:
Distribution Information (Fund Website)
Please note the fund is an ETF, hence the distributions are fully covered. There is no concept of return of capital in the ETF structure.
Call options not appropriately structured for growth equities
What is faulty regarding the design of this fund is the call options structuring:
Options Details (Fund Website)
The fund rolls 1-month options, but it structures in the money calls. In the money references options which are below the current trading level in the index. This is a very defensive positioning, and works best when an index is going down in price. In financial engineering terms the options have a high delta.
The issue with this overlay is that the upside is nonexistent. Whereas some funds do 1% or 2% out of the money options, this one does not leave any upside. If the index stays at the same levels or goes up in value, the written options will get exercised. While there is nothing wrong with being defensive, this ITM structuring does not work long term for growth equities.
Growth equities are those stocks which come from companies experiencing a high rate of income growth, thus they tend to rally substantially during bull markets. By structuring in the money options, the fund basically does not capture any of the upside offered by growth stocks.
Long term the ETF performance is illustrative of this build:
During the past two years, the Invesco QQQ Trust (QQQ) is up 31% while FTQI is up only 12%. More importantly, other instruments from the buy-write cohort, namely the Columbia Premium Technology Growth Fund (STK) and the JPMorgan Nasdaq Equity Premium ETF (JEPQ) are up roughly 25%.
While FTQI will have narrower drawdowns due to its structure, its upside is very much capped by its very defensive stance. We feel investors looking to extract dividends from growth stocks need an approach that captures the upside as well, an approach that is more appropriately shown by STK and JEPQ. Since JEPQ is a new fund, let us look at only 3 of the names above on a longer time-frame:
They say a picture is worth a thousand words – just look at the above graph plotting the total return of the three names in the past decade. While QQQ and STK are up over 400%, FTQI is up only 63%. The difference in performance is staggering and tells the story why growth stocks should not have very tight option overlays.
What should a retail investor do?
If you already own this name you can hold on to it since it is still generating solid positive annual returns, however better alternatives exist. As highlighted above, new money looking to extract dividends from the Nasdaq would do well to allocate to STK or JEPQ since those funds appropriately track the index on a total return basis.
FTQI is not a bad fund on its own, it is just a very poor structure for the underlying growth equities. Growth is about high capital appreciation figures, appreciation which is foregone via the written call options which are very close to spot levels.
The only valid choice for FTQI is in a perceived down market, when an investor still wants to have Nasdaq exposure:
The above graph is the performance for the cohort in 2022, when the market was down substantially. FTQI outperformed since its build is very conservative. Thus FTQI is only a robust choice in a perceived down market scenario.
Conclusion
FTQI is a buy-write ETF. The fund aims to extract dividends from the Nasdaq, and it currently has a 11% dividend yield. The fund is very conservative via its options overlay, options which are done in the money. This structure only works best for growth equities in a down market, while vastly underperforming in bull markets. New money would do well to look at STK or JEPQ, while current holders can continue owning the name for the dividend but understanding they are giving away a significant portion of the potential upside.
