Growth vs. Income in QQQ-derivatives

On Discord, we often have discussions on growth vs. income. Since we are mostly all Theta Gang traders, we gravitate toward income-generating strategies by using both defined and undefined risk spreads or Wheel trades to create cash flow. In other words, we find ways to manufacture dividends, even on stocks that don't pay dividends. 

At some point, traders like myself become interested in putting some of our portfolios into buy-and-hold positions. Since we may not have the time, energy, or risk tolerance to trade a dozen different Theta Gang plays, we want to set aside some of our money into either growth or income (i.e. dividend) positions.

But should we invest in pure growth plays like SPY or QQQ? Or should we park our cash in high-dividend stocks and ETFs to generate literally passive income? 

The arguments can get heated. In this post, I'll address my thoughts on this important topic. I'll use several different ETFs associated with the NASDAQ to demonstrate these points. This post assumes that the trader wants to withdraw money at some point, rather than leave it invested until they die. After all, there is no point in outperforming the market every year if you never exchange the money for goods and services.

Keep in mind there are similar sets of stocks with other indexes. I am only choosing to follow the NASDAQ derivates because it is the set in which I personally invest.

All Growth: TQQQ

Growth Score: 10
Income Score: 0

Young and aggressive investors typically argue that we should not invest in dividend ETFs because they almost always underperform the base index itself. They are correct; growth outperforms dividend over the long-term. I cannot think of any exceptions to this.

Those who are particularly adamant about seeking growth can turn to triple-leveraged ETFs like TQQQ. The market has an upward bias. Therefore, tripling-down into bullish markets can bring about remarkable gains even without dividends. When you need to generate income, you can liquidate a small portion of your portfolio to fill your needs. Presumably, the smaller share position will be offset by the increased value of each share.

In autumn 2016, TQQQ was trading for a little over $10. Today, it's over $130. This would be a gain of 13x despite very little dividend being paid during this time and a handful of dramatic market pullbacks. Anyone planning their retirement would be pleased. If they need to sell some of their position for income, the reduced position size would be offset by increased value.

TQQQ actually does pay a dividend. However, it pays inconsistently and is usually <$0.03/quarter. There may as well not be a dividend.

Best for: Traders with high risk-tolerance and a willingness to actively monitor a position to ensure they are liquidating for income at opportune times. Alternatively, people who are young and seeking aggressive growth, but expect to be mentally prepared to switch to more conservative ETFs later.

The issue: From April 2018 to September 2019, TQQQ was flat. Anyone who counted on liquidating TQQQ for income would have had to sell shares without an offsetting increase in price. Any prolonged period of time in which the market is flat will force the trader to dig into principle in order to generate income. This is unsustainable.

Additionally, prolonged market downturns crush 3x leveraged assets. Depending on the level of beating, it can be difficult to recover. A multi-year downtrend could push TQQQ down below redemption, destroying principle. Although TQQQ did not begin trading until 2010, it stands to reason that TQQQ would have suffered a devastating downturn between mid-2000 and late 2002 when the NASDAQ lost more than 70%. TQQQ would likely have had to reverse-split to stay solvent, if not go defunct.

Also, 3x leverage means that if the NASDAQ were to lose 20% to hit its circuit-breaker in a devastating day, TQQQ would lose ~60% with little prospect of recovery.

Growth: QQQ

Growth Score: 8
Income Score: 2

Moderately aggressive investors who prioritize growth but want to eliminate the risks of 3x leverage should consider the base indexes. In the case of the NASDAQ, the ETF is QQQ. This is my largest investment at about 25% of my portfolio.

The technology sector is a relatively aggressive sector in general. Tech stocks typically have higher P/E ratios and higher volatility than other sectors like utilities. However, the trader is also rewarded with above-average growth.

Just as with TQQQ, anyone who needs a consistent payout can liquidate a portion of their holdings to generate income. The increased value of each share will offset the reduced number of shares. In most years, this partial liquidation will outperform dividend ETFs and recover quickly.

QQQ was $117 in autumn of 2016. Now, it is $362. This gain is almost exactly 3x after accounting for dividends paid out over that time. 

Over the long term, QQQ, being the NASDAQ's base indexed ETF, has many advantages. Growth is consistent and reliable. Management fees are very low. There is almost no chance of the ETF going insolvent as there is with TQQQ. And although the 0.50% dividend isn't turning any heads, it is nice to get the occasional payout.

Best for: Investors with long-term outlooks who do not have the desire to pursue the most aggressive gains found in leveraged ETFs. Also ideal for buy-and-hold investors who are not interested in Theta Gang strategies.

The issue: Just as with TQQQ liquidation, the partial liquidations of QQQ require that the trader reduce his position side to free up money. In years when the NASDAQ decreases, the trader would be forced to reduce his position size without an offsetting gain from share appreciation. 

This effect is particularly evident during the dot-com bubble of 1999-2000. Investors who put their money on the line in 2000 had to wait until 2013 to recover those highs. This is not entirely problematic if the trader is buying between 2001-2012 and averaging down. However, the 12-year gap is not an acceptable timeframe if the investor intends to liquidate shares for income. 

With the exponential share appreciation over the past 15 months, we are more likely currently in the middle of another 2000 than another 2013. 13 years into a bull market, we should start considering the possibility of a substantial pullback in the near future. I know people have been saying this since 2014, but eventually, that shoe will drop.

QQQ is therefore not a suitable hold when someone is looking for income. QQQ should be held by those looking for growth, and investors who are ready to move to income should take gains and gradually shift to dividend-focused ETFs.

Balance: QYLG and QQQX

Growth Score: 3
Income Score: 7

These are both remarkably similar instruments that write covered calls against the NASDAQ index to gain premium, which is then passed to investors as dividend. 

QYLG and QQQX are very similar securities.
QYLG is an ETF that writes covered calls on 50% of its NASDAQ holdings all the time, no matter what. It pays dividends monthly.
QQQX is a mutual fund that writes covered calls on 35%-75% of its holdings depending on market conditions. It pays dividend quarterly.

QYLG and QQQX differ, and if you are interested in these, I recommend reading about the details. However, they are remarkably similar and the way to play them does not change. I believe QQQX will beat QYLG over the long term because the variable 35%-75% coverage allows managers more flexibility during different market conditions. However, QYLG has not had a chance to prove itself because it started trading in September 2020. It may very well be the stronger performer.

By covering only a portion of its NASDAQ holdings, QYLG/QQQX save space for share appreciation, which allows the stock to recover from downturns by riding the recovery. This is different than ETFs that cover 100% of their holdings like QYLD, which we will review next.

The partial coverage also guarantees a substantial premium distributed to the shareholder every month (QYLG) or quarter (QQQX). If the dividend alone is not enough, the investor may still need to liquidate some of his holdings. However, these ETFs should minimize the need for liquidating because they pay 12-15x as much dividend as QQQ. If reinvested, these 6%-7% dividends snowball quickly and the payouts can last generations.

Although these securities do not have the volume of the more focused ETF like QQQ, a 10,000 share daily volume should be adequate for the retail trader.

Best for: Traders who are prepared to get off the QQQ roller coaster and enjoy truly passive income at the expense of missing out on additional growth. This is ideal for those who intend to lock-in gains as they approach retirement, those who do not want to actively manage liquidation of growth stocks, and those who do not want to trade actively at all. This is a great alternative to proper dividend ETFs like SPHD which receive dividends from individual companies to pass to shareholders (as opposed to QYLG/QQQX, which generate dividend by selling covered calls and therefore do not suffer long-term dividend cuts).

The issue: Although QYLG/QQQX are great securities, it is hard to find a place for them in a mature portfolio. By the time someone is ready to invest in dividend-focused ETFs, they likely already have a large position in QQQ, SPY, or another indexed ETF. To free up cash to invest in QYLG/QQQX, the investor would have to sell QQQ first, and thus pay capital gains tax. He would probably be better off liquidating QQQ slowly for income, rather than get nailed with taxes up front.

If someone does not intend to sell QQQ but still wants dividend, he would likely be better off adding QYLD to his QQQ, rather than sell QQQ for QYLG/QQQX. Adding one of these to QQQ may not be enough dividend, whereas adding QYLD likely will be since it is 2x QQQX's dividend. We will explore this more in the next section.

Dividend Only: QYLD

Growth Score: 0
Income Score: 10

QYLD has come to be known as "Quaaludes" in our Discord. This nickname comes from sounding-out the ticker QYLD, but there is another reason Quaaludes checks out: it is great for sleeping on.

QYLD does not grow. It is suitable for dividend only. However, its 11+% dividend paid out monthly is perfect for people who need consistent payouts but have no interest in trading any longer. They are sleeping on Quaaludes and still getting paid.

QYLD writes 30-DTE ATM covered calls on the NASDAQ index each month to collect premium. If assigned, the fund buys the index back and writes another ATM covered call immediately. This 100% coverage means there is very little room for the stock to climb during bull markets. QYLD's gain is always capped by the covered call, and there is little room for the stock to run before it hits its short strike. If the market were to completely melt down as it did in 2000, then it would take forever for QYLD to recover afterward, and the trader would have been better off in the base index.

Since 2016, QYLD has gone up and down a few percentage points in either direction, but overall, it has barely moved. It's nearly 12% dividend keeps the price bogged-down while pumping out its monthly distributions. If reinvested though, that dividend snowballs fast and can become a source of generational wealth.

QQQ has approximately 3x'ed since the summer of 2016. QYLD has gone up about 60% after accounting for dividends. Investors who held QQQ and liquidated 11% of its value each year have more money than those who invested in QYLD at the same time.

However, those holding QQQ have to actually liquidate, and they can't be sure where the market is going, and thus can't be confident they're liquidating the right amount. Meanwhile, QYLD investors could have slept right through the 2018 and 2020 market declines without even noticing anything happened. QYLD is for dividends and dividends only. If your goal is to acquire truly passive income, you can achieve it with QYLD.

Best for: People who are no longer interested in trading. People who do not have time to trade and need to have consistent income, even at the expense of any share appreciation. People who already own QQQ and want to add a dividend position to it.

I own a substantial amount of QQQ. QQQ is my largest position, however I do not want to sell QQQ to buy QYLG/QQQX because the tax implications would be heavy. Instead, I am making new additions to QYLD. My QYLD and QQQ positions balance out without me having to sell any shares. I now get a mix of growth from QQQ and dividend from QYLD.

The issue: QYLD does not grow. It does NOT grow at all. This is not a suitable investment for those who are seeking gains through capital appreciation. QYLD will underperform QQQ, even after accounting for dividends, except during very flat markets.

In fact, QYLD has actually gone down since its inception in late 2013 if you ignore dividends. QYLD has paid out more than 100% of its IPO price in dividends since that time. However, QQQ pulled a 4x during this same time. Although QYLD has increased in value since its IPO after including dividends, it has certainly underperformed its base index.

In exchange for sacrificing those gains, the investor receives a virtually guaranteed payout with precisely zero effort. It is up to the investor to determine if that is the right instrument.

Like I said prior, I own a lot of QQQ. Adding QYLD grants me a dividend without having to liquidate any QQQ. QYLD also offers me more dividend than QYLG/QQQX, so using QYLD balances my growth and income holdings more quickly.

Tax Implications

Some of these investments, specifically QYLD and QQQG, pay out part of their dividends as a "return of capital." In other words, they're giving you some of your own money back. This sounds suspicious, but it is actually better for the investor than receiving a dividend.

In a return of capital, the investor does not pay any tax on that distribution. Instead (as far as the IRS is concerned), that return of capital reduces your cost basis on the shares you purchased. Therefore, you may be paying more taxes on capital gains when you sell the shares. However, if you never sell the shares or if you are in the 0% bracket, then you might as well consider a return of capital as a tax-free dividend. To truly calculate what you owe the IRS on your distributions, you would need to look at dividend filing data and calculate how much is a return of capital vs how much is an actual dividend and file taxes accordingly. No one does this. Just do what your broker defaults to.