QQQI: High-Yielding, Tax-Efficient Income Investment

NEOS NASDAQ-100(R) High Income ETF (NASDAQ:QQQI) is the latest in the option income ETF world, offering a high yield, tax efficiency, and potential for capital appreciation. After researching the fund strategy, mechanics, and performing a risk analysis, I believe the fund is worth considering as an income investment for those looking for predictable monthly income.

Fund Strategy and Performance

QQQI Strategy

Incepted only a few months ago on 1/30/2024, QQQI is an actively managed ETF with $76.5M AUM and a 0.68% expense ratio. QQQI seeks to generate high monthly income in a tax efficient manner with the potential for equity appreciation. The underlying exposure and index QQQI tracks is the Nasdaq-100, which is an index comprised of 100 of the largest and most innovative non-financial companies listed on the Nasdaq based on market capitalization, as shown in the holdings’ breakdown below.

QQQI essentially operates the same as Neos S&P 500(R) High Income ETF (SPYI), which I wrote an article on in November 2023, but uses the Nasdaq-100 instead of the S&P 500 for its options strategy.

Fund Strategy Summary:

• The Fund aims to deliver high monthly income by investing in Nasdaq-100 Index constituents and employing a data-driven laddered call option strategy.
• Managed by NEOS, it actively seeks tax loss harvesting opportunities and utilizes NDX Index options, which are subject to the lower 60% long-term/40% short-term capital gains tax rates.
• The fund seeks to capitalize on potential gains in rising equity markets through a call option strategy involving both selling and buying call options.

QQQI Performance

Since inception, QQQI has slightly outperformed Invesco QQQ Trust ETF (QQQ), the Nasdaq-100 surrogate in terms of total return, however this is such an ultra-short timeframe I’m merely showing this to reflect how the fund tracks its underlying index. QQQI has a current TTM yield of 14.28%. Per NEOS Co-Founder Garrett Paolella, the fund’s goal is to provide a yield of 12-15% while maintaining prospects for capital appreciation.

To give an idea of performance response using the funds’ strategy, I included the same YChart for SPYI. Since inception, SPYI has underperformed SPDR S&P500 ETF Trust (SPY) S&P 500 surrogate by about 10% in terms of total return starting late last year. Near the end of 2023 is when SPY rapidly broke out, showing an example of when a fund with an option overlay strategy will underperform. Otherwise, the fund did quite well, tracking the S&P 500 until this point. Of note, SPYI’s price appreciation is 1.82% since inception.

QQQI Mechanics

Index Options

Index Options have several benefits compared to regular equity option transactions, as summarized in the diagram above. For one, regular equity options like selling covered calls against QQQ are taxed at 100% of your ordinary income (short-term capital gains) tax rate. Settled index options get a favorable 60%/40% long/short-term capital gains tax rates respectively per Section 1256 contracts.

Dually, options are cash-settled and are European style which expire on the date per the contract and cannot be called away before that date, unlike American style options which can be called away at any time. These two features help with cash flow predictability, which is one of the primary reasons an investor chooses an option income ETF like QQQI.

Tax Efficiency

In doing more research into SPYI and now QQQI, I appreciate fund management’s priority of maximizing tax efficiency for after-tax total returns. In addition to earning qualified dividends from the equities held and utilizing the more favorable index options, management also applies tax loss harvesting throughout the life of the fund, with the ability to carry forward losses indefinitely per the ETF structure. Losses are paired against distribution income to classify part of income as classified as Return of Capital (ROC) which are essentially deferred long-term capital gains.

ROC is a payment that an investor receives as a portion of their original investment and that is not considered income or capital gains from the investment. Note that the return of capital reduces an investor’s adjusted cost basis. Once the stock’s adjusted cost basis has been reduced to zero, any subsequent return will be taxable as a capital gain.

The ROC portion of the distribution, reported through Form 8937, defers taxes by first lowering investors cost basis at the end of each year. Once your cost basis is zero, all distributions will be taxed at the long-term capital gains rate so long as the shares have to be held for more than 1 year per the IRS. I calculated, per SPYI’s 19a-1 Notices every month, that > 90% of SPYI’s distributions are classified as ROC, which I expect to be similar for QQQI. The combination of tax efficiency and high yield are attractive for income investors like myself, who would hold this fund in a taxable brokerage account to supplement income and offset my emergency fund.

Income Generation and Capturing Upside

Understanding the tax implications, let’s delve into the management of income generation and upside potential. The fund employs a strategy of selling options 6-7 weeks out-of-the-money (OTM) with a strike price set 1.5%-4.5% higher on average. This approach is structured as a call option ladder to capture a portion of the potential upside as well. Typically, calls are written on 70-80% of the portfolio, with adjustments made as necessary to meet the income target of 12-15% yield. Once the income objective is achieved, distributions are carefully managed to maintain the 12-15% target yield, with any excess income reinvested into the fund to grow the Net Asset Value (NAV). The remaining portion of the portfolio is left untouched to benefit from potential equity appreciation.

On top of standard equity appreciation, the fund may also buy long calls as a form of risk management when volatility is compressed, much like in 2017, for example, when the Nasdaq marched up higher and higher month after month. This ensures more upside is captured than the standard option ladder play alone. To determine this, the fund looks at the volatility measure or VXN for the Nasdaq-100, which is synonymous with the VIX of the S&P500, to be less than 12 or 11. For reference, they do the same thing for SPYI when the VIX is < 10. QQQI’s requirement is higher due to the Nasdaq being 10-25% more volatile than the S&P 500.

Risk Analysis

The two primary risks I see are the active management and inflation. Although a data-driven model is used, this fund is not on a passively managed auto-pilot function. Real human decisions are being made to execute trades and structure the ladder, so this opens investors up to human error and emotional decision making potential by fund management. On the other hand, not using an automatic method opens investors up to more opportunity to actually outperform its benchmark under the right market conditions. Although quick upward movements will drive this fund to underperform its index, it can actually outperform the index in a declining or flat market.

The second risk I see is inflation, specifically that the distributions will not keep up with inflation without reinvestment. As an income and dividend growth investor, I’m ultra-focused on inflation each year. For option strategy funds, I’m tracking the price appreciation as a means to drive distributions higher than inflation and the average distributions themselves. As noted previously, SPYI’s price appreciation is only 1.82% since inception in August 2022.

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The average rate of inflation since 2022 was 2.97%. Cumulatively, that’s about 6% while the cumulative distribution of SPYI has increased 4.91%. The actual inflation rate in 2022 was 8% which shouldn’t be a frequent event, so I believe SPYI can catch up, all things being equal. To manage an inflation risk trend for SPYI or QQQI, investors could utilize less of the income, say 8%, and reinvest the rest into its respective fund.

Moving Forward

QQQI has definitely piqued my interest as a candidate as a tax-efficient high-yielding investment. I struggle with BDCs and REITs in my taxable brokerage because I like the higher yields and diversification, but do not like the tax liability compared to my qualified dividends from dividend growth stocks. An option income ETF like QQQI gives the best of both worlds. I would be highly motivated to hold 5-20% of my taxable brokerage in funds like QQQI as a means of covering my core expenses and beyond. This is because far less capital is required compared to dividend growth stocks to reach my ~$2700/month goal, so long as the fund’s total return can significantly outpace inflation.

Ultimately, I would like to track QQQI’s total return, price return, and distribution growth for more time before investing a significant amount of money, but I believe a “Buy” rating is still appropriate for those ready for predictable monthly income. I’d be interested in fund management’s feedback regarding inflation for funds operating like QQQI and SPYI. I don’t believe investors should be responsible for determining how much of their distribution to reinvest to outpace inflation. I’d rather the distributions be optimized for high yield and slight inflation outperformance for sustainability and peace of mind.