A few weeks ago, I wrote a cautious follow-up article on the YieldMax TSLA Option Income Strategy ETF (TSLY). Since day one, I have been cautious on the YieldMax products like the TSLY ETF, as its headline 60%+ distribution yield appeared too good to be true. Furthermore, investors buying these ultra-high distribution yield ETFs may be setting themselves up for large tax bills, as the income from written call options is mostly considered net investment income (NII) while capital losses are unrealized until the units are sold.
My cautious views seem to have generated a lot of comments as well as a few angry direct messages. A few common themes from the responses to my TSLY article seemed to be that most commentators were market timers who bought TSLY near the lows so they have much better experience with the TSLY fund. Furthermore, some commentators were happy to pay taxes since it showed they made profits, and finally, other YieldMax products like the YieldMax NVDA Option Income Strategy ETF (NYSEARCA:NVDY) had performed much better because they did not have as many bears like myself affecting sentiment.
While I cannot comment on the market timing abilities of TSLY investors, I do want to take some time to discuss other aspects of the YieldMax ETFs using the NVDY ETF as an example.
Like TSLY, the YieldMax NVDA Option Income Strategy ETF is an actively managed exchange-traded fund that seeks to generate high current income by writing call options on Nvidia (NVDA) stock instead of Tesla (TSLA) stock.
The NVDY ETF and its family of sibling funds achieve their objective by creating “synthetic covered calls” on the underlying securities. A synthetic long exposure to NVDA is obtained by selling puts on the underlying stock while simultaneously buying calls (Figure 1). This synthetic long options strategy gives the NVDY ETF virtually the same exposure to Nvidia shares without the high initial capital outlay.
Against this long-dated synthetic long, the NVDY ETF will sell shorter-term out of the money (“OTM”) call options to ‘harvest’ the option premium income. NVDY currently holds a synthetic long with March expiry, while it has sold call options with a January 26, 2024 expiry (i.e. weekly options) (Figure 2).
Different Funds Have Different Yields
The key difference between the TSLY and NVDY is that while the former advertises an eye-popping 67% headline distribution rate, the latter only has a 32% headline distribution rate (Figure 3).
TSLY’s eye-polling yields have allowed it to gather more than $800 million in assets while the NVDY only has $158 million. Why does the TSLY ETF have much higher yields, and does that make it a better investment?
Distribution Yields Driven By Implied Vol
If we were to simply compare distribution yields, we can see that the TSLY ETF is in fact not the highest yielding YieldMax ETF (Figure 4). YieldMax offers a similar fund based on Coinbase shares with a 165% headline yield or AMD shares with a 73% yield.
The key concept to understand with the YieldMax ETFs is that the headline distribution yield is simply a reflection of the differing levels of implied volatility of the various stocks, and does not necessarily indicate that the TSLY is a better investment than NVDY (Figure 5).
In fact, if we look at total returns, we can see that NVDY has massively outperformed TSLY since its inception, with a 53% total return since May 11, 2023 compared to just 9% for TSLY (Figure 6).
Since NVDY has outperformed TSLY, does that mean NVDY is a buy?
NVDY Still Trades Upside For Premiums
The answer is, it depends. Like all covered-call funds, the NVDY ETF is also trading off upside returns for option premiums. So if the underlying stock has large rallies, the NVDY ETF will underperform. For example, since inception, the NVDY ETF has returned 53% compared to 108% for Nvidia shares (Figure 7).
On the other hand, while upside returns are capped, downside is uncapped. So if NVDA shares start heading down, the NVDY ETF may offer little protection from capital losses.
While currently Nvidia is a stock market darling due to its leadership position in artificial intelligence, investors should not forget that as recently as 2022, NVDA’s shares saw a 50% drawdown (Figure 8). In that situation, the NVDY ETF will likely suffer significant losses as well.
At the end of the day, investors considering these YieldMax ETFs should ask themselves two questions. First, they should ask whether they are bullish on the fundamental outlook for the underlying stock, be it Tesla or Nvidia. Next, if they are confident in the outlook for the company, are they willing to trade away a significant portion of the upside in exchange for distribution yields?
Limits To Capital Loss Deductions
Finally, investors should ask themselves whether they want a high current tax liability.
In effect, the YieldMax products are just converting unrealized capital gains and NAV into distributions, without the tax benefit of those distributions being considered ‘return of capital’ (ROC). As we have pointed out in our TSLY article, the YieldMax ETFs may saddle investors with high current income tax liabilities, as option premiums are mostly considered net investment income (“NII”), while the ETF itself may suffer unrealized NAV declines (Figure 9).
While high net investment income may be offset by capital losses, there is a limit to how much capital losses can be deducted from ordinary income. Investors should consult a tax professional to determine what their tax liabilities will be from investing in a YieldMax ETF.
The YieldMax NVDA Option Income Strategy ETF provides investors with high current income from writing short-term covered calls on Nvidia stock. Investors should look beyond the high distribution yields of these YieldMax ETFs and ask themselves a few questions before buying.
First, they need to ask whether they believe in the outlook for the underlying stock, be it Nvidia or Tesla or Coinbase. Next, if they are bullish on the shares, do they want to trade away the ‘upside’ for a high headline yield? Finally, do they want to have to convert unrealized capital gains and NAV into high current tax liabilities?
For me personally, I believe Nvidia shares are dangerously overvalued, so I would personally avoid the NVDY ETF.