A few weeks ago, I took a look at the QYLD ETF, or what I like to call q-yield, which
uses a covered call strategy on the Nasdaq 100 index to provide investors with a 12%
annual dividend paid monthly.
I got a great response from that video, which I really appreciate, but I also got a handful
of comments saying that the NUSI ETF, which I’ll call NUSI, is even better, with a current
annualized yield of about 8% paid monthly.
So in this sort of a sequel to my QYLD video, we’ll be taking a deep dive into the NUSI
ETF, which is the Nationwide Risk-Managed Income ETF.
We’ll start by breaking down the fund’s strategy, which has some interesting parallels
and surprising advantages over the QYLD ETF.
By the way, if you want some more context to the QYLD comparison, be sure to check out
that video for all the details.
Next, we’ll compare how NUSI performs in different market environments, and how it
compares to QYLD in each one.
Then, we’ll discuss the taxation of dividends from the NUSI ETF.
This is huge to consider for any income-focused investor, and I personally learned a lot by
taking a closer look at the fund’s clever tax strategy.
Finally, I’ll share some of my thoughts on NUSI based on what I’ve learned picking
apart a few of these options-based income funds.
Here we go!
NUSI uses something called a protective net credit-collar on the Nasdaq 100 index.
I know that sounds like a bunch of random words, so we’ll break it all down starting
with the underlying index.
To start, NUSI invests in the Nasdaq 100 index, which are the 100 largest stocks by market
cap trading on the Nasdaq, excluding financial stocks.
The Nasdaq is considered to be heavy into tech businesses, so this is going to include
stocks like Apple, Amazon, Tesla, Facebook and so on.
This also makes the Nasdaq 100 a more growth-oriented investment, which has outperformed the S&P
500 so significantly in recent years.
Investors can easily access the Nasdaq 100 with the QQQ ETF, which holds all 100 of its
stocks weighted by market cap.
However, NUSI purchases each individual stock to replicate the holdings of the index exactly,
which is also the approach that the QYLD ETF uses.
Of course, being a growth-oriented index, many of the stocks in the Nasdaq 100 pay little
to no dividends.
The NUSI ETF uses a two-step options strategy to generate cash flow from its Nasdaq 100
holdings, which allows investors to collect monthly dividends while also benefiting from
some of the upside potential of the underlying stocks.
And this is where we get into that protective net-credit collar term.
The NUSI Protective Net-Credit Collar Strategy The protective net-credit collar is made up
of two steps: first selling a covered call, and then buying a protective put strategy.
Let’s take a look at how this unfolds.
The covered call strategy is the primary tool for generating cash for the fund, and thereby
dividends for investors.
Covered calls are an options strategy that can be employed when you own the underlying
shares.
In this case, because NUSI owns shares that replicate the Nasdaq 100 index, they’re
eligible to sell a covered call contract on the Nasdaq 100 index.
When selling a covered call, you give someone else the right to buy your shares if the price
increases to a certain point, known as the strike price.
The buyer pays you what is known as a premium for this contract.
If we take a look at the QQQ ETF as an example, trading just under $329 at the time of writing,
we could sell a covered call with a $330 strike price.
In doing so, we’ll get paid approximately $11.34 per share in premium.
But if the price moves up to $330 and the buyer chooses to exercise the contract, we’ll
be forced to sell our shares at that strike price, forgoing any additional profits that
we might’ve earned if we just held onto our shares without creating the covered call
contract.
On the other hand, if the price doesn’t move up, we can keep our shares and the cash
we collected in premium.
And this is the exact strategy that NUSI uses on its Nasdaq 100 holdings, but it sells a
covered call on the entire Nasdaq 100 index rather than individual holdings.
This has a few key differences from selling covered calls on shares.
First, these call options will be settled in cash, not by selling the underlying shares
to the buyer.
So instead of liquidating or transferring holdings, NUSI would simply pay the cash value
if the option is exercised.
Second, unlike stock call options, index call options cannot be exercised early.
They can only be exercised at expiration, so in this case, the price of the Nasdaq 100
index doesn’t matter too much until that final day where the buyer has the opportunity
to exercise.
But overall, the covered call strategy that NUSI uses is a simple and effective way to
generate cash from the Nasdaq 100 index.
They repeat this every month to generate consistent cash flow and fund their monthly dividends.
The one risk with this strategy is that you pretty much eliminate any chance of capital
appreciation, because you are capping your potential gains at the strike price you select
for the call option.
For investors who prefer dividends to capital appreciation, this may work just fine, but
it’s not the most effective strategy in a bull market because you’ll be missing
out on returns via growth.
But we’ll talk more about market conditions in a minute.
The second component of the NUSI strategy is known as a protective put option.
They’ll use cash they earn from selling the covered call to purchase one of these
options, which provides downside protection.
Buying a put option gives you the right to sell your shares at a set strike price, regardless
of where the shares might actually be trading at.
So if you own a stock at $100 and you’re worried it might drop, you could buy a protective
put with a $95 strike price.
This way, if the price drops below that $95 mark, you’ve locked in your ability to sell
your shares for $95, capping your potential losses at $5 per share.
This will limit any significant losses that might be caused by sudden market movements.
So in the case of the NUSI ETF, the fund will purchase a put option just below market price.
Again, this protects the value of the portfolio and prevents substantial losses.
This is a unique component to the fund that we don’t see in QYLD or other covered call
ETFs, and we’ll talk more about how that impacts returns in a minute.
To recap, the fund will first sell a covered call for a cash premium.
It uses some of this to purchase a protective put, limiting downside risk.
Whatever cash is leftover is paid out to investors via a monthly dividend distribution.
The fund will also distribute capital gains via dividends on an annual basis, which will
be made up of any dividends from the underlying holdings or the sale of any holdings.
Finally, if there is any premium leftover above their targeted distribution rate, they’ll
reinvest it into their underlying holdings which should drive continued portfolio growth
over time.
So now that we understand how NUSI works, I want to consider how it might perform in
different market environments, and specifically in comparison to QYLD.
First of all, both of these funds benefit from a volatile market.
More volatility means that options premiums are higher, so both funds will generate higher
amounts of cash from selling covered calls.
However, this benefit may be less noticeable depending on which direction the market moves
in.
In a rising market, as we touched on earlier, you have the risk of triggering the covered
call option that will have to be settled at the end of the month.
This will effectively limit the growth of the portfolio.
On the bright side, the fund still gets the cash premium from the covered call, so the
dividend will be unaffected.
But in these cases, investors are usually better off holding the underlying assets,
perhaps via the QQQ ETF, where they can enjoy a higher total return.
This is where QYLD falls short in my opinion.
However, NUSI has a distinct advantage in this situation.
The covered call options can only be exercised by the buyer at the end of the month, and
the fund managers have the ability to close out these positions early at their discretion.
So, if it looks like the underlying holdings of NUSI are going to increase significantly,
they can close out the call option and prevent making that cash settlement at the end of
the month.
With this strategy, they can uncap the growth of their holdings, enabling investors to benefit
from some of the capital appreciation that you completely miss out on with QYLD.
So I really like that this fund still has the potential for some upside growth, but
this also comes with the risk of trusting that the fund managers will make the right
decision, which is not a guarantee.
Overall, we would expect NUSI to perform slightly better than QYLD in a bull market, even though
it’s still not the preferred strategy for investors seeking highest total return.
In a falling market, NUSI should outperform other covered call strategies.
It’s protective put component will limit portfolio loss while continuing to provide
dividends for investors.
QYLD on the other hand, has no downside protection and nothing to limit losses besides cushioning
them with covered call premiums.
So a falling market is really where NUSI shines.
In a flat market, both of these funds will generate dividends for investors while the
underlying assets may not be producing returns, which could be a great way to earn returns
in an uneventful market.
However, with lower volatility, these dividends may also be lower.
QYLD is likely to outperform NUSI in these cases, because it’s not using its premium
to buy protective puts.
Therefore, it will have more cash to distribute to investors.
In comparison, NUSI will be producing lower dividends because of the costs of its protective
put strategy.
If you compare QYLD to NUSI over the last year, we can see these benefits in action.
Obviously, NUSI fared much better during the massive sell-off in March thanks to its protective
puts.
But interestingly, it doesn’t seem like NUSI has offered substantially more growth
since then.
Although it may have had some periods of outperformance, QYLD offered slightly higher returns since
the recovery started in April of 2020.
Unfortunately, NUSI has only been around since 2019, so we don’t have too much information
to look at to see if it will really deliver extra returns through growth over the long-run,
even though it's designed to have that potential.
As an options-driven income strategy, the NUSI ETF has some important tax implications
for investors.
Ordinarily, the cash settled index options used by NUSI are taxed 60% at the long-term
capital gains tax rate and 40% at the short-term capital gains tax rate.
So when the cash premium is directly passed through to investors, that would be the breakdown
for tax purposes.
However, if NUSI distributes capital gains to investors, these could be taxed at short-term
or long-term rates depending on how long they held the shares from which they realized returns.
So you could actually be getting a pretty diverse mix of dividend sources and tax treatments
from NUSI distributions.
But it turns out this isn’t the case, as I discovered that they’ve actually been
distributing dividends made up almost entirely of return of capital, which led to some deeper
research.
For the cash designated as a return of capital, there are no immediate tax obligations at
all.
Instead, taxes on these dividends will be deferred until you sell your shares.
This means that as the dividends are currently made up, investors are essentially collecting
tax-free distributions which can provide a lot of benefits.
While a return of capital can definitely be a bad thing in some cases, it looks like NUSI
is actually using it to benefit investors.
With this strategy, investors have more flexibility on when they pay taxes on their distributions.
This can accelerate dividend reinvestment or simply provide more cash up-front, compared
to receiving standard dividends taxed as capital gains.
We can tell that this is beneficial for investors because the NAV of the fund is still growing,
creating a total return that is greater than the distribution rate.
This means that the return of capital distributions are not currently eating away at the NAV or
putting the portfolio at risk.
Therefore, investors can enjoy tax benefits without worrying about their initial investment
losing value with each distribution, which is exactly what you want to see.
I know this can be a complicated topic, so I went in depth with everything about return
of capital in a previous video.
Be sure to check that out for everything you need to know surrounding these kinds of distributions.
Overall, I was expecting to like NUSI more than QYLD due to its downside protection.
After all, losing portfolio value is one of the biggest risks with these yield-oriented
investments, and we saw that the protective put strategy certainly works to preserve capital.
When you combine this with the potential for NUSI to offer growth exposure to the Nasdaq
100 index, it seems like a strong choice.
However, there’s no clear indication yet that this is actually working.
Maybe after a few more years of data we’ll have a better idea, but for now, NUSI has
yet to provide any substantial growth over QYLD.
So based on what we’ve seen so far, I feel like NUSI only makes sense if you’re expecting
some really bad times in the market and need to maintain some level of income from your
investments.
Again, in a flat market, QYLD is likely to perform better, and in a bull market, you’re
better off holding the underlying assets via the QQQ ETF for a greater total return.
One of the interesting things to me is that there are so many funds that use the covered
call strategy to generate income, but the ones built around the Nasdaq 100 seem to be
the most popular.
You also have options like XYLD which use the S&P 500 or RYLD which use the Russell
2000.
Ultimately, the Nasdaq 100 has the highest volatility, which means it will generate the
highest premiums and the highest dividend yields for investors, which probably explains
the popularity.
But in all of these cases, if you understand how the underlying options strategies work,
you’ll have more control over your investments if you just purchase shares of the index ETFs
and perform the strategies yourself.
You’ll also save on expense costs.
On the downside, you’ll forgo the passive convenience of an ETF and miss out on the
potential benefits of return of capital if that’s something you’re interested in.
In any case, I’ve been fascinated to learn how many different ways you can piece these
different instruments together to customize an investment strategy based on your goals.
And at the end of the day, that’s what I find so interesting about investing and what
inspires me to continue learning more.
I hope you guys enjoyed this breakdown of the NUSI ETF, and if you have any questions
or feedback I would love to hear from you in the comments.
Otherwise, I’ll see you guys next week.