XYLD: Volatility-Adjusted Distribution Offers Excess Return

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XYLD’s distribution income is actually highly correlated to market volatility.

DNY59

Foreword

This is part 2 of our covered call ETF series. Before reading this article, we strongly recommend that you read our part 1 of the ETF series on covered calls on Global X NASDAQ 100 Covered Call ETF (QYLD). The summary of part 1 is as follows:

  • We explained that the objective and methodology of our covered call strategies is to actively generate income without giving up benefits and that our strategy differs from passive covered call strategies (e.g. QYLD ).
  • We’ve also explained why it’s structural for ATM-covered call option ETFs to lose value over time.
  • Although the price of QYLD has steadily declined over the past 9 years, historical distributions of QYLD remain relatively constant throughout. This increases QYLD’s dividend yield every year.
  • Since the Nasdaq (commonly referred to as the tech sector) is generally associated with growth rather than dividends or income generation, we found no reason to try to derive income from it through QYLD . Therefore, QYLD has significantly underperformed its underlying index over the past 9 years.

Introduction

Global X S&P 500 ETF Covered Call (NYSEARCA:XYLD) is Global X’s covered call ETF that shares a similar strategy to QYLD. Both ETFs involve selling ATM call options on their underlying index. This means that XYLD and QYLD give up any upside potential for a fixed profit, while bearing the downside risk.

Fig 1. XYLD and QYLD strategy

Fig 1. XYLD and QYLD strategy (overall X)

Since XYLD is similar to QYLD, many analysts and investors are indifferent to it, while others wonder which is the best ETF. However, this study found concrete evidence to suggest that XYLD is superior to QYLD. Let’s examine.

XYLD vs. QYLD: distribution quality

Distribution characteristics of QYLD

The distribution of QYLD has remained relatively constant over the years (Fig 1) despite a steady decline in the share price (Fig 2). QYLD has distributed a total of $20.80 per share or an average annual return of 9% unfunded since the start of 2014 (Fig 3). This has 3 significant negative implications: (1) investors can buy the same amount of future cash flow if they wait, (2) prior investors are forced to reinvest their distributed income and average dollar cost to profit from QYLD . The second implication is not feasible for many people who have other distribution goals, such as pension costs.

Fig 1. Historical distribution of QYLD

Fig 1. QYLD Distribution Remains Relatively Constant Despite Falling Prices (Author, www.globalxetfs.com) (Author, Global X)

Fig 2. Steady decline in QYLD prices

Fig 2. Steady decline in QYLD prices (Y-Charts)

Fig 3. QYLD distribution history since January 2014

Fig 3. QYLD distribution history since January 2014 (Author, Global X)

The 3rd implication is perhaps the most important, ie the distribution of QYLD is not adjusted by volatility. According to the Black-Scholes option pricing model, the distribution of QYLD (option premium) should be positively correlated with volatility. The more volatile the Nasdaq, the more revenue QYLD should generate.

Figure 4 shows that the distribution of QYLD is rather weakly correlated with Nasdaq volatility. The correlation between QYLD distribution income and Nasdaq volatility is only 0.315, which is a low correlation by definition.

This may also explain why QYLD strongly underperformed the Nasdaq where QYLD’s distribution could not keep up with volatility.

Fig 4. Nasdaq Volatility vs. QYLD Distributed Income - Normalized Change

Fig 4. Nasdaq Volatility vs. QYLD Distributed Income – Normalized Change (Author, Global X)

Distribution characteristics of XYLD

On the other hand, XYLD has distributed $26.54 since the start of 2014, which averages a dividend yield of 7% per year. However, the distribution of XYLD over the past 9 years is steadily increasing (Fig 5). Therefore, XYLD’s current yield is actually over 7%. For example, XYLD’s returns in 2021 and 2022 are close to nearly 10% and 10.5% respectively. Since XYLD engages in covered options at the money, this means that XYLD’s upside is capped at the premiums received while bearing the full downside risk. Therefore, XYLD is expected to remain in a range or downtrend (Fig 7), which offsets the premium yield.

Fig 5. XYLD annual distribution

Fig 5. XYLD annual distribution (Author, Global X)

Fig 6. Cumulative XYLD distribution since 2014

Fig 6. Cumulative XYLD distribution since 2014 (Author, Global X)

Fig 7. XYLD Price Changes

Fig 7. XYLD Price Changes (Y-Charts)

The main difference between the distribution of XYLD and QYLD is how the distributions correlate to the volatility of the underlying index. As shown in Figure 4, the distribution of QYLD has little or no correlation with its underlying index. However, the distribution of XYLD is strongly positively correlated (=0.87) to its underlying index (Fig 8).

This means that XYLD compensates investors for the additional risk (volatility), but QYLD does not.

Fig 8. S&P500 Volatility vs. XYLD Distributed Income - Normalized Change

Fig 8. S&P500 Volatility vs. XYLD Distributed Income – Normalized Change (Author, Global X)

Does XYLD really have superior returns?

It’s easy to dismiss QYLD as not having a higher risk premium because QYLD (average annual return = 4.9% since 2014) has significantly underperformed the Nasdaq (23%). It’s also easy to mistake XYLD as having a higher risk premium because its average annual return (5.4%) is closer to the S&P500 (11%).

We also know that XYLD has risk-adjusted distributions, while QYLD does not. Yet this does not tell us whether investors are being properly compensated.

For this, we must look at the risk premium, which is defined as the return compensated for taking risk (volatility).

Contrary to popular belief, the S&P500 has always been more volatile than the Nasdaq (Fig 11). It is easy to perceive the Nasdaq as being more volatile than the S&P500. The return of the Nasdaq almost doubled that of the S&P500 during the 2020-2021 bull market (Fig 9) and also declined more than the S&P500 during the 2022 bear market (Fig 10). This is not really the case (Fig 11).

For the period between 2014 and 2019:

  • QYLD and XYLD have very similar average total returns:
    • The average total return of QYLD is 7.5% (=(total distribution of $13.52 – capital losses of $2.03) / $25.54 Closing price on December 31, 2013 / 6 years)
    • The average total return of XYLD is 7.7% (=(total distribution of $13.92 + capital gain of $6.50) / closing price of $44.17 as of December 31, 2013 / 6 years)
  • QYLD and XYLD have very similar required returns depending on the risk involved:
    • The beta of QYLD and XYLD relative to their respective indices is 0.0978 and 0.1756. This means that XYLD is more risky and should demand a higher return.
    • Assuming an average risk-free rate of 2.5%, the resulting required return for QYLD and XYLD is 4.42% (=2.5%/12 + 0.0978*[1.84%-2.5%/12]) and 4.412% (=2.5%/12 + 0.1756*[0.98%-2.5%/12]) respectively.
  • QYLD and XYLD provided a very similar excess return to investors.
    • Excess Return QYLD = 7.5% – 4.42% = 3.08%
    • Excess Return XYLD = 7.7% – 4.412 = 3.288%

QYLD and XYLD also have similar excess returns for the period including the pandemic era (post-2020), although XYLD provided slightly more (0.6%) excess return than QYLD.

  • Excess Return QYLD = 4.9% Avg. Yield – 4% required. Yield = 0.9%
  • Excess Return XYLD = 5.4% Avg. Yield – 3.9% Required. Yield = 1.5%

Fig 9. S&P500 and Nasdaq during the 2020-2021 bull market

Fig 9. S&P500 and Nasdaq during the 2020-2021 bull market (Y-Charts)

Fig 9. S&P500 and Nasdaq during the 2020-2021 bull market

Fig 10. S&P500 and Nasdaq during the 2022 bear market (Y-Charts)

Fig 11. Market volatility: SPY vs. Nasdaq

Fig 11. Market volatility: SPY vs. Nasdaq (Author)

Verdict

This study found strong support for claiming that XYLD is superior to QYLD:

  • The distribution of XYLD is highly correlated to market volatility, unlike QYLD. Therefore, XYLD and QYLD may have increasing returns over time, but increases in return for XYLD are derived from an increasing distribution while increases in return for QYLD are derived from falling prices. This means that XYLD investors do not need to keep reinvesting to realize the yield increases, unlike QYLD investors.
  • XYLD is able to provide approximately 10% higher excess return than QYLD given its risk and market performance pre-Covid, and 67% post-Covid.

That being said, investors should remember that XYLD and QYLD have very limited upside potential and will not be able to take advantage of a strong bullish reversal in the market. Although we find XYLD to be superior to QYLD, we still retain our preference for hoarding blue chip dividend value stocks now for income (read Part 1 to find out why). We also maintain our position to invest in XYLD only if we believe that the market will stagnate while remaining very volatile.

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