Earn 6% On An Index Fund Portfolio? QYLD Revisited

| About: Recon Capital (QYLD)

Summary

QYLD should not be seen as a stand alone investment, it should be used as a hedge against QQQ.

This investment strategy can be used to enjoy the growth of the Nasdaq 100 while earning a solid amount of monthly income.

If you want to take things a step further, this strategy gives you the ability to sell options on QQQ and juice up your income even more.

I recently made a post about the Recon Capital Nasdaq 100 Covered Call ETF (NASDAQ:QYLD). You can see it here.

QYLD Revisited:

Upon more study of QYLD I realized that my previous analysis of this investment did not do it justice. In my other article I looked at the ETF primarily as a standalone investment designed to be held during a bear market but this does not seem to be the role QYLD was designed to perform.

I now believe this ETF should be seen as a hedging tool and never held alone. An investor who is long on the NASDAQ 100 (NASDAQ:QQQ) can buy QYLD to protect the position he has on market index. In the right conditions a portfolio comprised of these two funds should be able provide downside protection and stability while keeping most of the NASDAQ 100's heady growth.

All this while enjoying a dividend payment much higher than the average index fund.

Click to enlarge

Before we start I want to recap some things for people who have not read my initial thread:

For those who are unfamiliar with the term "covered call," it is an options strategy synonymous with buy-writing. When an investor buy-writes a security he buys the security while simultaneously selling a call option on the same position. For selling this call option he is instantly given a cash payment called the "premium," but incurs the obligation to sell his stock (at a set price) to the option buyer whenever the buyer wants it. This obligation exists for the duration of the contract. Option contracts can have durations of weeks, months and even years.
The call option writer benefits when the price of his stock stays flat because if the price increases the options buyer will exercise the contract, forcing him to sell his stock at a price lower than the market price. However, If the price declines or stays flat the option buyer will probably not exercise his right to buy the stock and the option writer is cushioned from potential losses by the cash premium he received to engage in the contract."

Basic ETF Stats.

Price: 22.12

Yield: 8.55% (Distributed Monthly)

Expense Ratio: 0.60%

Net Asset Value: 22.28

Premium to NAV: 0.13

Assets under management: $40.11M

Introduction:

When it comes to investing I think that retail investors have two options if they want to be successful in the stock market. This is just my personal opinion and should not be taken as profession advice:

  1. If you have a low risk tolerance and don't want to trade actively you should put 100% of your money into an index fund. These are ETFs like: the SPDR S&P 500 Trust ETF (NYSEARCA:SPY), the SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA) or QQQ. Market Index funds are usually made of blue chip company stock and are diversified beyond anything you could ever make on your own. The logic here is that the majority of investors don't beat the market anyway, so why even try?
  2. If you don't want to buy the market don't even bother diversifying. Find one great stock/industry that you think will beat the market and put all your money it.

The following article will be geared towards people who would rather just buy an index fund and coast with the market.

The NASDAQ 100 Index ETF: QQQ

The NASDAQ 100 is generally the best performing of the large market indexes, it is the only one I buy when I want to invest in the market without choosing a particular stock. You can invest in the NASDAQ 100 with the ETF QQQ and its 3x leveraged version, the ProShares UltraPro QQQ ETF (NASDAQ:TQQQ).

^DJA Chart

^DJA data by YCharts

The problem with the NASDAQ 100 tends to be its volatility. As you can see during the tech bubble in 2001 and the recent market corrections this is definitely the riskiest of the major market indexes.

Another problem with QQQ is its small dividend yield, a paltry 1.3%. This is unacceptable for investors who want to be able to profit from an investment without having to sell it. Using QYLD as a hedge against your long position on the NASDAQ 100 alleviates these problem and makes for an excellent 2 security diversified portfolio.

The Numbers:

Lets assume we have $100,000 to invest and we have decided that we will not try to beat the market this year. Our portfolio will be composed of two stocks: QQQ and its buy-write counterpart QYLD.

Investing like this is called creating hedge. We limit the risk our portfolio by combining two stocks with behavior that counterbalances. When the market is booming QQQ gives us growth and QYLD slows us down a little while giving us income. On the other hand when the market goes south QYLD steps up and protects us from loosing too much money.

Portfolio components

Long QQQ Long QYLD
$50,000 $50,000
1.30% dividend yield: 10.8%
Click to enlarge

Total

$100,000

Dividend Yield: 6.05%

Performance of QYLD vs QQQ:

First I want to show the Total Return of the ETF, a figure I neglected to mention in the previous article. Total return is what the price would be if dividends where reinvested.

Instead of being -10.5%, the return of QYLD is 12.18% from 2014 to 2016 when dividends are considered.

QYLD Chart

QYLD data by YCharts

QYLD vs QQQ

QYLD Chart

QYLD data by YCharts

In this hypothetical 50/50 portfolio made up of QYLD and QQQ you would have ended up with $108,975 after this period of time and you would have collected around 6,000 a year in dividends. This is a reasonable trade off to make for the security that hedging your index ETF portfolio gives you. I think something like this will usually perform better than anything from a financial advisor.

Conclusion.

QYLD is a perfect hedge for the NASDAQ 100 and this makes it a pretty solid investment. This is great and all but I am not going to recommend anyone to actually invest money in the stock market right now. Why? Because not even a hedge will protect you from the full fledged recession which I believe can happen at any moment now. Market indexes should always be bought when the market is low and avoided while it is near its top.

All that being said, in good bull market conditions a buy write ETF like QYLD is the perfect way for investors to earn income while their safe diversified portfolio reliably increases with the market.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.