Why QQQX's Premium Disappeared

QQQX briefly outperformed the market by a large margin, but its NAV returns have always been mediocre.\nWhile QQQX has a compelling mandate and investment style, opportunistic buying of the fund should wait for a wider discount.\nThe semi-passive covered call approach benefits less volatile indices than the Nasdaq 100.\nThe Nuveen Nasdaq 100 Overwrite Fund (QQQX) is one of the more interesting closed-end funds for a variety of reasons. For one, it’s a high income tech fund, meaning investors are getting a 6.8% dividend yield from a portfolio of Nasdaq 100 stocks, far above the index fund (QQQ) dividend yield of 0.86%.That’s not too surprising for a closed-end fund ((CEF)), which often exist to deliver as much income as possible to investors. But compared to its CEF bretheren, it’s unusual in that it is much more of a passive fund than an active one. Although it is not entirely passive, its mandate has very strict rules on how it can invest:“The Fund is designed to offer regular distributions through a strategy that seeks attractive total return with less volatility than the Nasdaq 100 Index by investing in an equity portfolio that seeks to substantially replicate the price movements of the Nasdaq 100 Index, as well as selling call options on 35%-75% of the notional value of the Fund’s equity portfolio (with a 55% long-term target) in an effort to enhance the Fund’s risk-adjusted returns.”QQQX, like the Nuveen S&P 500 Dynamic Overwrite Fund (SPXX) and the Nuveen Dow 30 Dynamic Overwrite Fund (DIAX) combines a covered call option strategy with a portfolio of stocks in the index to provide a higher income stream.While this never translated into market outperformance on a NAV basis, investor enthusiasm for QQQX made it a market outperformer on a price basis during the recovery years of 2016 and 2017, although its NAV remained far below QQQ:

This enthusiasm resulted in the fund’s discount quickly turning into a premium, which spiked at double digits in early 2018:

As you can see from this chart, that premium has disappeared and resulted in a steady slide towards a discount, although it has remained around par for most of 2019 as market enthusiasm for equities combines with speculation on QQQX’s future. The question now is whether QQQX’s recent history of a high premium will return or if it will go back to its older trend of trading at a discount.Why QQQX’s Premium VanishedTo answer that question, let’s first look at the price and NAV returns during that discount spike. When we compare them with QQQ’s returns, it quickly becomes apparent why this premium appeared so quickly.

As you can see, QQQX’s total NAV return underperformed the index on a consistent basis throughout 2018—a fact that the market chose to ignore for several months, until in July finally capitulating and beginning the trend of QQQX’s price going south. This is an important lesson in itself: CEF investors act much slower than the broader market, and a price correction that should happen in a day can occur slowly over weeks or months.CEF investors should have started selling QQQX in March 2018 when the fund was overpriced; since they didn’t, an opportunity from then until the end of May appeared to play the momentum of this fund’s increasingly inefficient pricing by going long for a few weeks, before the premium disappeared in July.Now, the question is whether QQQX investors will buy back into the fund and price it up to another high premium or if the high premium is likely to remain a blip in the history of an otherwise underperforming fund.This is unanswerable because of the inefficiency of the CEF market. However, to what extent CEF investors make rational purchasing decisions based on data, it seems likely that QQQX will not reach its premium. At the very least, the risk/reward profile of buying QQQX before it reaches a larger discount is too high, as the probability of a large premium reappearing is much lower than it was in 2016/2017, when CEF demand was surging AND stocks were climbing high very fast.Index Risk and QQQX’s Call OptionsThe reason is that one theoretical benefit to QQQX has in fact turned into a liability. Remember that QQQX tries to sell call options on a little over half of its portfolio on average over the long run. The income received from the premium on those sold call options is accounted for as capital gains, but if the premium collected from those call options is smaller than the capital gains that would have been received if the shares were held, the covered call strategy is actually resulting in lower returns (but, in theory, less volatility).To understand this a bit more, let's take a hypothetical example. Stock ABC trades at $10 and call options with a strike price of $11 sell for $1. Because of market volatility, ABC's share price falls to $9, and now the same call option with a strike price of $11 sells for $0.60 (the implied volatility of the option has gone up slightly, but the premium has fallen because of the larger distance between the current market price and the strike price); at the same time, $10 call options are now $1.00. If QQQX sells $11 call options against ABC, the total collected premium has fallen. If QQQX sells $10 call options against ABC, the premium collected is the same, but if ABC reaches $10, QQQX has sold at a lower profit (or a loss) relative to if the market was less volatile and QQQX was able to sell options at an $11 strike price.When actively managed, a covered call fund can result in less volatility at the NAV level because of this strategy, but in the case of QQQX, the market price volatility for QQQX has exceeded that of QQQ. In other words, the benefit of less volatility is not passing through to investors:

At the same time, investors are seeing lower returns both on a NAV and price basis relative to the index because of the lower returns caused by these sold call options. QQQX has been delivering no less volatility and lower returns on a NAV and market price basis, hence its big premium rapidly dwindling. This is different from what we have seen with QQQX’s sister funds, DIAX and SPXX.

Over the last 3 years, DIAX has beaten DIA on a NAV and market price basis. SPXX has met the index on a market price basis, although its NAV return has lagged the index:

Finally, a quick look at QQQX shows its underperformance is much worse than SPXX’s on a NAV basis:

Comparing these three, we see a gradation in which relative NAV performance is inversely proportional to the risk of each index (remember QQQ is historically more volatile than SPY, which is itself more volatile than the blue chip-based DIA):

During this period, the volatility of each index has remained mostly correlated in the same range, with QQQ being the most volatile and DIA being the least, with the gap between QQQ and SPY/DIA much larger than between SPY/DIA:

From this alone we can quickly conclude that the higher the volatility of the index the worse the covered call fund returns will be, and that there is a very short cliff in which outperformance turns into underperformance (i.e., the gap between DIA and SPXX).For the most part historically, this inverse relationship between the risk of the index and the relative performance of the relatively passively managed covered call fund tracking it has held, but the relative underperformance of QQQX has grown recently.

As you can see by comparing this chart with the volatility chart, the gap in underperformance worsened when volatility increased. Here is QQQ’s volatility compared to QQQ/QQQX’s total NAV returns:

Larger gaps between high and low volatility periods for QQQ has resulted in QQQX’s growing underperformance. The explanation for this is very simple and intuitive: higher volatility results in higher premia from selling call options (good for QQQX) as well as a higher risk of options being assigned and better performing stocks being sold, while worse performing stocks remain in the portfolio. This is obviously bad for the fund as a whole.A way to avoid this is to focus on an index where the gap between underperforming and overperforming stocks is smaller, so that when volatility strikes it does not create as big of a discrepancy between winners and losers that results in a lower quality portfolio as winners are sold and losers are held. Hence higher volatility with DIA did not impact DIAX’s alpha:

For a more volatile index like QQQ (or, for that matter, SPY), the solution to this problem would be a more active approach that combines an analysis of the portfolio to sell call options more strategically.The Bottom LineNow is not the time to buy QQQX, despite the resurgence of QQQ. A more active approach could help the fund over the long term, but a more short-term opportunistic approach to the fund would make sense if its discount widens significantly beyond its current level. QQQX is a good fund with an appealing method to capturing income from a tech-heavy growth portfolio, but timing is crucial to avoid overpaying and capitalizing on the fluctuations within the CEF market.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.