A 15.7% Yield with a Growth Engine

This closed-end fund mimics the tech-rich Nasdaq 100 Index. The fund’s holdings include tech giants Apple, Microsoft, Qualcomm, Cisco, Google and Intel. While the tech sector is not known for its generous dividends, QQQX boosts income by writing call options on the Nasdaq 100 Index. In total, QQQX has received nearly $6 million in premiums from these options, compared to total assets of $206 million.

For the last eight quarters, QQQX has paid out a steady dividend of $0.4625 per quarter, or $1.85 annually. At current prices, that represents a rich yield of 15.7% ($1.85/$11.77). Investors should note that in 2008, 85% of the distributions have come from return of capital. That means the fund has had to dig into its own equity to keep the dividend at the current rate. Its called “return of capital” because the fund is essentially returning your own money. The fund has a fairly reasonable expense ratio of 1.05%, which takes a small bite out of total returns.

Investors should also be aware that tech bellwethers are known for their potential for strong gains, but also their high volatility. For instance, the Nasdaq carries an average beta of about 1.2 (as measured against the S&P 500) over the past five years. This means the index is roughly 20% more volatile than the S&P. As a group, they have not been immune to the economic downturn. While the tech sector did outperform the broader S&P 500 over the last 12 months, the Nasdaq has still lost -27.9% versus the S&P’s -34% decline.

Still, the largest tech stocks, as measured by the Nasdaq 100, have led the market year-to-date, with a gain of +17.5% against the S&P’s +1.8%. Also helping the tech sector is the fact that many of these companies carry little or no debt. As credit remains tight, the sector has a clear advantage by not needing to rely on the credit markets.

This has helped QQQX perform well. The fund has delivered total returns of +35.9% year-to-date. This return has been boosted by the fund’s option-writing strategy. During volatile markets, this strategy is especially lucrative. With higher volatility, the amount QQQX receives from writing a call option increases. This is because higher volatility means there is more of a chance the call will be exercised. Therefore, the premium demanded is higher and the willingness of an investor to pay that premium is also increased.

The option-writing strategy also serves to cushion QQQX in down markets. When the market falls, the equities within its portfolio will also fall. However, the calls written are also less likely to be exercised — meaning the fund gets to earn the premium on the calls without having to supply the underlying shares.

Still, as the market returns to a more normal trading range, the fund may be harder pressed to produce the same level of option income, which may pressure distributions. Despite rising nearly +30% in 2009 and returning almost 10 percentage points more than the Nasdaq 100 Index over the last year, QQQX still trades at a -4.9% discount to its net asset value. This is on the low end of its historical average discount, but is still in an enviable range.