Similar to mutual funds, exchange-traded funds (ETFs) are collective investments. However, ETF shares shares are listed and traded on major stock exchanges.
ETFs took off with the 1993 launch of the S&P 500-tracking SPDR fund. At end-2022, there were 8,744 ETFs in issue worldwide. By end-2022, $10trn was invested in these funds globally.
One unusual new ETF
Most ETFs passively track a particular index or benchmark. However, the number of active funds is growing, as providers come up with more esoteric investments.
Earlier this month, one interesting new fund caught my eye. Launched on 13 September, the $14.6m Defiance Nasdaq 100 Enhanced Options Income ETF (NASDAQ: QQQY) is unlike any ETF I have encountered.
This fund takes advantage of the huge surge in trading short-dated options since early 2020. Options are derivatives — financial contracts that give one the right (but not the obligation) to buy or sell something at a pre-determined price on or before a future date.
Call options increase in value as the price of the underlying asset rises, while put options gain value as the price falls. Generally, calls appeal to bulls (optimists), while puts appeal to bears (pessimists).
Generally, options are geared, or leveraged, so they magnify gains or losses. And very short-dated options have become extremely popular with US day traders and high-frequency players.
How does QQQY work?
QQQY pockets the premiums from selling daily put options to generate monthly income. Also, it provides market exposure to the underlying Nasdaq-100 tech index.
The fund keeps most of its assets safely in cash and highly liquid US Treasury bonds. It then buys Nasdaq-100 index options to provide a return from this index. At the same time, it also sells ‘zero days to expiration’ (0DTE) puts.
Put simply, this ETF sacrifices some of its ongoing index returns by selling ‘in the money’ puts to boost its income. And there is no shortage of buyers for these wildly volatile securities.
0DTE options are exploding
Trading of 0DTE options linked to the S&P 500 and Nasdaq indexes has exploded this year. According to the latest data, zero-day options now account for half of all S&P daily options volume. Currently, the daily notional trading value of 0DTE options exceeds $1trn. Wow.
Because of their ultra-short-dated nature, most 0DTE options expire worthless. However, writing put options is not a risk-free business, so this ETF could suffer during periods of extreme market volatility. Indeed, an 0DTE-related dislocation might rattle markets similar to the ‘Volmageddon’ incident of February 2018.
In a rising market, the QQQY fund should underperform the wider Nasdaq-100 index. However, if the index keeps falling, then the fund’s options income should help to curtail its losses. Hence, over time, it should be less volatile and record smaller drawdowns than the index it tracks. Also, returns will be reduced by the 0.99% annual management fee.
Would I buy QQQY today?
I would not buy this new ETF today for two reasons.
First, as a veteran investor with 37 years in markets, my family portfolio is well-constructed, diversified, and balanced. Thus, I don’t overly worry about my Nasdaq-100 exposure and its volatility. Second, the near-1% yearly fee will reduce this ETF’s returns substantially over time. I’ve always disliked paying high fund fees, so I’m not about to start now!
