The Gift That Keeps On Giving

| About: Nuveen Nasdaq (QQQX)
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Recap of what happened in QQQX over the past weeks.

A fundamental look at QQQX vs. QQQ.

What the situation looks like as of 3/23/2017.

We have all heard the expression 'a gift that keeps on giving' and any seasoned trader knows that this is rarely applicable to the capital markets because they are so efficient. Well, this does not seem to be the case with Nuveen NASDAQ 100 Dynamic Overwrite Fund (NASDAQ:QQQX). This old friend of mine has proven to be a real roller coaster who attempts to defy fundamentals and statistics.

A Brief Recap

As you probably remember, in early February, I wrote an article on the topic as it had popped on my radar. From all perspectives, the trade seemed to be solid. However, mania reached extremums never seen before and it turned out that the early bird does not always get the worm. Not only did the fund keep on deviating from its Net Asset Value (NAV) to insane levels, but it probably crushed most shorts as well.

I will not go into much detail, but instead will show you the peak of QQQX's madness in one simple chart:

Source: The author's software

On Friday, 3/17/2017, the fund reached a monstrous premium with the unimaginable 3.5 standard deviations from its mean. Anyone who shorted up there had a good time coming into this week.

Fund's Overview

Source: QQQX's website

Portfolio and Comparison with QQQ Holdings

As of 2/28/2017, QQQX has 186 holdings with the top 10 being:

Source: QQQX's website

QQQ's top 10 holdings are almost the same, but it is slightly less diversified with a total of 108.


One would be convinced just by looking at the funds' portfolios that they are highly correlated, which is far away from what we have observed over the last two months.

Returns Comparison with QQQ

Let us take a look at how both QQQX and QQQ have performed historically.

Source: Morningstar

One of the arguments I have heard lately about QQQX's price performance is that its Option Writing strategy has been causing it, but how come this is not reflected in the NAV of the fund? Any insight is appreciated if anyone believes that this is a valid argument.

Source: Morningstar

It is crystal clear that Nuveen NASDAQ 100 Dynamic Overwrite Fund is not outperforming QQQ in a justified manner even without looking deeper into it, but it is our duty to do so.

Portfolio Comparison

As I pointed out in the beginning of the article, QQQX had its peak in terms of premium last week and we did actually witness a revert to mean on Wednesday, but it only took it one single day to drift away once again.

Source: The author's software

The clear observation from the screenshot is that historically the closed-end fund's price does indeed have a strong correlation with QQQ. However, recently, this is not the case. In fact, as you can see, the revert to mean was a short-lived victory, because, as of yesterday (3/23/2017), QQQX is once again on the run, this time with 1.5 standard deviations from its supposedly rightful place.

To further prove my point, we can take a look at how QQQX's NAV has been doing in the meanwhile:

Source: The author's software

Yes, you guessed right. The correlation is absolutely broken. And the reason for this is QQQ outperforming QQQX's NAV.

So far, what we have found is the following:

  • QQQX's price outperforms QQQ for a significant part of 2017.
  • The former's NAV, on the other hand, is underperforming QQQ vastly.
  • This pair is providing us with a heavy arbitrage opportunity.

What we know so far is that once QQQX's price is on the run, we should be jumping right in front of the train while making sure that we can handle the pain all the way up to three, maybe even four, standard deviations. While still paying attention to the net asset value of the fund, of course.

Taking all of the information into consideration, the right course of action here, since we cannot trade QQQX's NAV directly, is to hedge our position with QQQ long. Additionally, we need less dollar value in QQQ to make this work because of its higher beta.

Statistical Reasoning Behind the Arbitrage

In terms of Z-Statistic, the fund is one of the most overvalued in the whole CEF department. As of yesterday, the one-year stands at 3.38 (Source: Morningstar).

Or as the chart below suggests, the fund has seldom experienced such volatility in discount and you can see for yourself how much this has skewed the Premium/Discount ranges below:

Source: The author's software

Lately, the fund is experiencing irrational buying, unless someone knows something and has been 'preparing' for it over the last two months, which, most probably, is not the case.

What could potentially skew the chart above and reshape it in the long term is a drastic reduction in the fund's Expense Ratio, but it is unlikely to happen. We will explore it further in the fundamental model below.

Fundamental Reasoning

Your model does not have to be incredibly complex in order to work, and I believe that QQQX is one of the easier closed-end funds to take on because of its relatively simple strategy and clear benchmark. I have constructed two portfolios, taken all the parameters that can change the valuation and calculated the discount of the fund in a way that both QQQ and QQQX's cash flow streams have the same internal rate of return. The results seem to confirm the discount levels at which the latter has been trading historically.

We will start off with the parameters used:

  • ROA - return on assets: This is one of the main parameters for the model. The bigger the expected ROA, the more you don't care about the expense ratio.
  • Expense ratio - the expense ratio for the CEF: The differential between this parameter and the expected personal expenses to replicate the fund's assets is one of the main reasons funds trade at different premium/discounts.
  • Personal expenses: In the case of QQQX, I am taking 0.20% as the personal expense, because I believe QQQ is a perfect way to mirror the assets of QQQX. QQQ has an expense ratio of 0.20%
  • Taxes on distributions: I have chosen 20% for both the portfolios, but the effect of taxes is really small compared to expense ratio and ROA. I don't believe that QQQX can have any significant difference in taxes paid. Please bring some more knowledge on the tax consideration so I can make better calculations.
  • Fund outperformance: There are some funds that are believed to constantly outperform the general public (PIMCO funds, for example). When that is the case, valuation is very sensitive to this parameter, and you can end up justifying even 50% premiums just because the fund's assets are constantly beating you with 20%. For QQQX, we have not seen any outperforming. I believe that the risk-adjusted returns are almost identical between QQQX's NAV and QQQ's NAV.
  • All other parameters are 0 for QQQX's case.

Source: The author's spreadsheet

The $4.8 difference in cash flows is due to the higher Expense Ratio of QQQX. This is the reason why I believe that investors should prefer it over its benchmark QQQ, only if it trades below -6.62% discount.

Based on my model and several assumptions - 0% outperformance by QQQ and 10-12% ROA - these are the levels at which QQQX should be trading:

Source: The author's spreadsheet

You can see in the chart above that QQQX would end up trading at a discount, which is, in fact, bigger than the one observed over the past year at certain moments, but is mostly consistent with its historical performance. Of course, there could be something I have missed or a fraction of the market might like the aforementioned closed-end fund more than QQQ itself. Last but not least, the model presented here fails to adjust for the volatility between the two instruments, so it definitely is not perfect yet.

In fact, according to my calculations, the Expense Ratio which would allow QQQX to trade at a premium in a justified manner should be 0.05%, or something very close to it.

Having all of this information, let us take a look at possible issues we may encounter while approaching the pair trade, with the risk of repeating myself from the previous edition of the article.

What Can Ruin the So-Called "Arbitrage" Fundamentally?

  1. Liquidation - The assets of the fund are large-cap common stocks that will be very easy to liquidate, and there will be no mean reversion.
  2. Special Tax Treatment - I have no idea how this can happen, but if it happens, there will be no mean reversion.
  3. Expense Ratio Cut - Management may decide they need less money to manage the fund. Sounds reasonable considering they are doing nothing special, but highly doubtful.

What Can Ruin the "Arbitrage" Technically?

  1. No supply of shares to borrow, which was a huge problem for me while trying to scale up in the trade, thus missing out on the sweetest part of the fund's upward movement.
  2. The buyer does not need fundamental logic, he just likes QQQX and he is very rich.
  3. High hard-to-borrow rates.

Latest News About the Fund

  • This is a link to the SEC filings.
  • This is the link where all the fund's literature can be found.

By now, it is sort of confirmed that the insane movement, followed by a revert to mean, was not sparked by any news.

The Trade

I am short 1,000 shares of QQQX for every 160 shares long of QQQ. Anyone who is not interested in pair trading but has QQQX somewhere in their portfolio should also consider their reasoning of holding the fund at these inflated levels. A mean reversion would occur if the fund reaches a discount level of -3.5% discount and is my initial target of closing the trade.


Despite the fact that this particular fund has proven that it has no regard for statistics and fundamentals lately, I still saw potential in making a recap and revisiting this pair trade idea. It probably gave a handful of us a lesson in timing trades and scaling them as the arbitrage continues to defy all odds.

At the end of the day, experiences like this one are what makes us push further and try to scrutinize every tiny bit of information.

Disclosure: I am/we are short QQQX.

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.

Additional disclosure: I am long QQQ