Mostly Voices [0:00]

A foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines. If a man does not keep pace with his companions, perhaps it is because he hears a different drummer. A different drummer.

Mostly Mary [0:18]

And now, coming to you from dead center on your dial, welcome to Risk Parity Radio, where we explore alternatives and asset allocations for the do-it-yourself investor. Broadcasting to you now from the comfort of his easy chair, here is your host, Frank Vasquez.

Mostly Uncle Frank [0:37]

Thank you, Mary, and welcome to episode 89 of Risk Parity Radio. Today on Risk Parity Radio, we're going to take a break from the email extravaganza, even though they continue to pile up, and we are going to do a 10 question analysis of the ETF QYLD as suggested by one of our listeners, Jamie E. And I think we should be able to complete that today. We'll be using David Stein's 10 Questions to Master Investing as our method of analysis. And here we go. Oh, I didn't know you were doing one. So question one, what is it? Well, QYLD is an ETF that is called the Global X NASDAQ 100 covered call ETF. And so what happens inside this ETF is it holds all 100 holdings in the NASDAQ 100. It is cap weighted, so it holds a lot of the top 10. 11% of it is in Apple and 9% of it is in Microsoft and another 9% in Amazon. And then besides that, it also has a covered call strategy. So it's following an index. Well, first of all, I should explain what a covered call strategy is. A covered call strategy is when you own a stock and then you sell a call against it. So, for instance, if the stock is trading at $100 a share and you own 100 shares, you could sell one call against it and in this instance you would sell near the price of the share so it's at 100. When you sell that you'll get a premium for selling that call. Now if the stock goes down or stays the same then eventually that call will expire worthless. If the stock goes up then your shares will get called away And so if the stock goes up to 105 during the period the option is valid, then the holder of that call will be entitled to buy those shares from you at $100 a share, even though they're worth 105. So the purpose of having one of these buy right or covered call strategies is to generate income by selling these calls on and investment in stocks. And so this particular fund is following what is called the CBOE NASDAQ-100 BuyWrite Index, which is also known as the BXN Index, which is a benchmark index that measures the performance of a theoretical portfolio that holds a portfolio of the stocks in the NASDAQ-100 Index and writes or sells a succession of one-month calls at the money reference index covered call options. In practice, I'm reading this from the summary prospectus that we'll link to in the show notes. It says each calendar month the fund will write a succession of one month call options on the reference index and will cover such options by holding the securities underlying the options written. Each option written will have an exercise price generally at or above the prevailing market price of the reference index. Second will be traded on a national securities exchange. Third will be held until one day prior to the expiration date, generally the Thursday preceding the third Friday of the month, and are liquidated at the volume weighted average price determined at the close, unless the fund closes out the option through the repurchase of the option at the market close on the last day of trading. And four, which option will expire on its date of maturity and five, only be subject to exercise on its expiration date and six, be settled in cash. In return for the payment of a premium to the fund, a purchaser of the call options written by the fund is entitled to receive a cash payment from the fund equal to the difference between the value of the reference index and the exercise price of the option if the value of the option on the expiration date is above the exercise price. The funds covered call options may partially protect the fund from a decline in the price of the reference index through means of the premiums received by the fund. However, when the equity market is rallying rapidly, the underlying index is expected to underperform the reference index. and it says this is a passive fund or index approach, so it does not rely on advisors making decisions. So from that description, let me just summarize. In this case, they're not selling calls on each particular stock in the NASDAQ 100, but they are selling them against this index. And the index represents the same thing. or is supposed to, if it's maintained properly, as the total of the NASDAQ 100. All right, I think we can move to question two because you can read about this in the links in the show notes if you're interested in more about question one.

Mostly Voices [6:15]

Place it over a candle and it's through the candle that you will see the images into the crystal.

Mostly Uncle Frank [6:22]

So question two is, is it an investment, a speculation, or a gamble? And in here, since we are talking about stocks and companies and a option strategy layered over on top of that, we would characterize this as an investment. This is a fairly common strategy employed by hedge funds and others to derive income out of a portfolio of stocks. So it's an investment. All right, what is the upside? Well, the upside comes in two ways. First off, there are the shares themselves, and if the Nasdaq 100 goes up, you'll get some return just off of that. And then second off, if this reference index falls after the fund buys the call option, then they will recover the entire premium on the call option. So every time they sell a call option on this reference index, they're getting a premium. Now, if the NASDAQ goes up more than the premium is worth, then the fund effectively loses money on that overall transaction because the call will be worth more than it was sold for. But if the NASDAQ 100 stays about the same or falls in value, then the fund will reap the benefits of the call and selling the call. So it's kind of a hybrid method of obtaining returns both from the NASDAQ 100 itself and these call options. All right, what is the downside? Well, it's this reverse of what I just told you. If the NASDAQ 100 goes up and you're selling calls against it, you're going to be losing money or because you won't be making as much money on the increase of the NASDAQ as you should have if you were just holding the NASDAQ and not selling the calls against it. So this fund actually works best when the NASDAQ is not moving much at all. This fund will also lose money if the NASDAQ declines substantially and you don't recover the decline value from selling the calls, which would also occur in a market crash scenario. In addition to that, there is an expense ratio of 0.6% for this, which is collected by the fund manager. Those appear to be the main downsides. All right, who is on the other side of the trade? Well, this thing is traded as an ETF, and so anyone can buy and sell it on your normal stock exchanges. This kind of thing is held by all kinds of Funds and individuals and sometimes some institutions, but institutions could implement this strategy themselves and may not need a fund to do it. In terms of those calls, those are also traded on these options exchanges. And so the options buyers would be on the other side of that trade. Question six, what is the investment vehicle? It is an exchange traded fund. So it's traded like a stock and can be traded whenever the market is open. Number seven, what does it take to be successful? Well, not a whole lot. You simply buy this thing and collect what returns you can out of it. If the NASDAQ is stable to up, you're going to make money. If the NASDAQ falls a little bit, you're probably still going to make money or break even. If the NASDAQ falls a lot, you're probably going to lose money. The one thing you should recognize though is that when the NASDAQ is going up, you are not going to make as much money as if you just held the NASDAQ 100. You'll be losing out on selling those calls because the calls will be worth more at expiration than they were when you sold them. All right, question eight. Who is getting a cut? Well, the fund manager is getting a cut. It's at 0.6% and that's about all who's getting a cut. The other party that could be getting a cut in this is the IRS because these kinds of strategies are relatively tax inefficient. You're collecting premium throughout the year on this kind of call strategy so there'll be income coming off of that. and you'll have to pay taxes on that income if you hold this fund in a taxable account. So you need to be aware that this is much less tax efficient than simply holding stocks. Anytime you're selling options and getting premiums, that is income for you for that year. All right, now getting to the more interesting question. Question nine, how does that impact your portfolio? and to take a look at that, I went and ran a correlation analysis of QYLD along with VTI, the Vanguard Total Stock Market Index, VIoV, a small cap value fund that we use, USMV, a low volatility fund that we use, and also TLT, the long-term treasury bonds and gold GLD, just for comparison purposes. and what you see on this is that QYLD has the same kinds of correlations you would expect out of a stock fund. It is 86% correlated with the total stock market index and less correlated with the small cap value or the low volatility fund. But it's highly correlated as a stock fund. It has an annual return that is less at least in recent times. This fund has only existed since January 1, 2014. And so in that time its annualized return is 8.64%. That compares with 13.88% for the Total Stock Market fund, 10.37% for the Small Cap Value fund, and 12.35% for the Low volatility fund USMV. So if you put this in your portfolio, it is likely to be a drag on it if you are substituting it for a stock market fund, which is what you would likely be doing since the of the high correlation, you wouldn't want to hold this and a whole bunch of stock funds because then you're just holding a whole bunch of correlated things. So you would be thinking of substituting this fund for one of your stock funds. And in this metric, it does not look like it would help you much. It looks like it would be a drag on the performance, at least in the kind of market environments that we've had since 2014. Now, you can imagine that this fund would probably do better in periods where the stock market is not moving around much and you're just collecting the premiums off the calls and the returns on other stock funds are close to zero, this fund would be making money off of that. This fund also would not lose as much money in a decline because it would also get the premiums from the calls, so you'd get something back on that. One other thing that's interesting to note, it has the same kind of standard deviation as the low volatility fund we use, USMV, which has a annualized standard deviation of 11.27 compared to 10.79 for QYLD and that's much lower than stock market funds, but it's still about the same as a low volatility fund. Now in addition to that correlation analysis, we also did a back test analysis at Portfolio Visualizer and what we did for this is we took the Golden Butterfly portfolio and that one is 20% Total stock market, 20% small cap value, 20% treasuries, long-term treasuries, 20% short-term treasuries, and 20% gold. And we did it two ways. We did it like that, which is the sample portfolio that we have. And then we did another analysis of the same portfolio except substituting QYLD for the total stock market fund to see what the results of that would be. and this was only a short back test because this fund has only existed since 2014. But looking at it, it does not look like this helps a portfolio to include this instead of another stock fund. The compounded annual growth rate for the original Golden Butterfly for this period was 7.78% compared to 6.75% for the fund with the QYLD in it. the best year was better for the original, the worst year was better for the QYLD. The maximum drawdowns were similar and the Sharpe ratio was slightly worse with the QYLD in it. So what we learned from this is that if you put this in your portfolio instead of one of your stock funds, it's probably just gonna make it a little bit more conservative and reduce the returns of it. All right, question 10. Should you invest? Well, probably not in this circumstance. If you're trying to use this in a risk parity style portfolio. And the reason is not so much that it's a bad fund or a terrible idea. It's just that you have better alternatives and simpler alternatives that if you want a more conservative portfolio, The main way of doing that is simply to reduce your exposure to stock market funds and not try to put in something that is kind of like a stock market fund, but with some kind of governor on it, if you will, that reduces its risk and reduces its returns. So in that sense, it kind of violates what we call the simplicity principle. If you can do something in a simple way, there's no reason to get a more complicated product or fund and stick it in there and do the same thing in a more complicated way. More complicated, mint is not better.

Mostly Mary [16:57]

That's not an improvement.

Mostly Uncle Frank [17:01]

What this also gets at is just more of that simplicity principle that we tend to want to avoid funds that are not the stock market but are kind of based on the stock market. And that would include all kinds of structured products and annuities and other indexed things that have bells and whistles on them and cost more to use. And this one does cost more to use than an index fund. It's 0.6% instead of an index fund, which is likely to be less than 0.1%. And what we've discovered is that the better choice in these kind of circumstances is not to be using these things with bells and whistles and guarantees and floors and ceilings and all that nonsense on it. but simply to reduce your overall exposure to the stock market using cheaper funds. And if you do that, you're going to have better results because you would have the same result with a lower fee structure. So I think this is a good example of why it generally doesn't make sense to use complicated products when you're trying to construct your own Risk Parity Style Portfolio that you're much better off sticking with what we would think of as the raw ingredients for this portfolio and not trying to take something that's already been modified and somehow meld it in when it's more expensive. And for instance, in this case, does not have nearly as long of a track record to know how it would really perform in all kinds of markets. And so it's for those reasons we would probably say thanks but no thanks to this sort of thing in our risk parity style portfolios. Or to summarize more succinctly as a wise man once said, Do you think anybody wants a roundhouse kick to the face while I'm wearing these bad boys? Forget about it.

Mostly Voices [18:57]

But now I see our signal is beginning to fade.

Mostly Uncle Frank [19:01]

Forget about it. I hope to issue another episode this week that it will be all emails since they continue to pile up. Just so you know, I do not generally respond to emails in writing because I want to answer the questions on the podcast so that everybody has the benefit of the answers. So that does mean that there will be a delay in getting your answer to your email and right now that delay is about 10 days at least. If you have an email, a comment or a question for me, send it to frank@riskparityradio.com that email is frank@riskparityradio.com or you can go to the website www.riskparityradio.com and fill out the contact form and I will get your message that way. If you haven't had a chance to do it, Please go over to Apple Podcast or wherever you get your podcasts and leave a five-star review because that just helps get the word out. Thank you once again for tuning in. This is Frank Vasquez with Risk Parity Radio signing off.

Mostly Mary [20:17]

The Risk Parity Radio show is hosted by Frank Vasquez. The content provided is for entertainment and informational purposes only and does not constitute financial, investment, tax, or legal advice. Please consult with your own advisors before taking any actions based on any information you have heard here, making sure to take into account your own personal circumstances.