The below is from a SeekingAlpha article Anthony Breen, CFA published on 11/1/2024.
The S&P 500's trailing ten-year total return is currently 254%, or 13.5% annualized the past decade. As a result of large cap tech becoming megacap tech over this time frame, the S&P 500 is ~35% weighted to 8 technology names (Magnificent 7 + Broadcom) and approximately 50% weighted to the Nasdaq 100 names. Investors who have half their equity exposure in the Nasdaq 100 and half their exposure in the S&P 500 may think they're diversified, but might not realize that they're 75% invested in the Nasdaq 100.
RSP, IVV, QQQ trailing ten year total returns. (YCharts)
The Nasdaq 100 returned 444%, or 18.5% annualized the past ten years. It's difficult to see how the Nasdaq 100 could repeat this performance in the next decade. To do so would make megacap technology companies have combined market caps worth multiples of US GDP. These are global companies that have defied the law of large numbers time and again, but at some point there are limits to above GDP growth. Valuations are certainly stretched with the Nasdaq 100 in aggregate trading at ~6.5 trailing 12 month sales and ~30x forward earnings. Which means average Nasdaq 100 after-tax profit margins stand at ~22%. (P/S)*(1/PE) = Earnings/Sales. 6.5*(1/30) = 0.2167. [Note: P/S source and P/E source.]
Although additional economies of scale could boost average profit margins incrementally from here, capitalism is eventually supposed to reward new entrants who can offer better value propositions and disrupt those margins lower. Excluding the Real Estate Sector, which consists of REITs with high margins cashing rent checks, the Information Technology Sector already has the highest margins of any other sector, coming in at 25% in the most recent quarter. The higher those margins go, the more vulnerable they are to higher taxation or regulation due to being "too profitable".
For the Nasdaq 100 to appreciate 5x over the next decade, presumably at least one or two of the Magnificent 7 would have to appreciate close to 10x, (to offset the underperformers). That would put the outperformers in the $20T - $30T market capitalization range, with US annual GDP around $45T by then. To support a $20-$30T valuation would require profits of around $1T per year, assuming a 20-30x PE ratio. In this theoretical scenario, it's easy to see how companies with $1T in profits would look like an easy target for Congress to attempt to balance the Federal budget.
Hopefully the above back of the envelope math gives you a framework for why Nasdaq 100 returns are unlikely to repeat those of the last decade. If returns are going to be more muted going forward, then investors should look to Covered Call strategies as a way to outperform. Given normal volatility levels, the breakeven point around which a 50% delta Covered Call fund underperforms or outperforms its underlying index is around price appreciation of 15% within 12 months.
In the last several years, major ETF sponsors have begun producing low-cost (0.29%-0.35% annual expense ratio) Covered Call ETFs to make the strategy easy for investors to access and implement. Most of these ETFs are called Premium Income ETFs instead of Covered Call ETFs to designate that there is Income coming from Call Premium.
The JPMorgan Nasdaq 100 Premium Income ETF (JEPQ) launched in May 2022 and has $17B in assets today. JEPQ aims to keep 50% of the upside price return of the Nasdaq 100, and give up 50% of the upside in exchange for covered call income. The covered call income is paid out to ETF holders as a monthly dividend. When the Nasdaq 100 VIX level is around 20, the monthly dividend rate is 0.75%, or 9% annualized. The monthly dividend fluctuates based on how much premium income is generated from call sales, and generally tracks the average implied volatility or VIX level during the prior month.
QQQ vs JEPQ total returns since May 2022 (YCharts)
If the Nasdaq 100 averages less than ~15% annualized returns over the next decade, then the Nasdaq 100 Premium Income ETF (JEPQ) with dividends reinvested [orange line above], should outperform the Nasdaq 100 (QQQ), [purple line above]. Of course, there are some tax implications of this strategy as dividends generated from covered call income are taxed as ordinary income. This makes JEPQ more ideally held in tax-deferred or non-taxable accounts.
The table below helps explain how Premium Income Funds are expected to do relative to their underlying index over the course of a full year. Note that, on a 1 day decline, they don't do materially better, as they don't have any downside hedge. The improved downside performance over time comes from slowly accumulating income in down markets.
Table of Expected 1-year Premium Income Returns Given S&P 500 Returns. Assumes average VIX level generates annualized dividends of 8%.
Above is a table of expected 1-year S&P 500 Premium Income fund returns under different S&P 500 1-year return scenarios. In flat or down years the premium Income Fund does 8% better. In up years the Premium Income Fund gets half the S&P 500 price return plus 8%. Therefore, it’s only in years that the index returns more than 16% that the Premium Income fund starts to underperform. Expected Return formula: IF (SPX Price Return < 0) Then SPX Price Return +8, Else 0.5*(SPX Price Return) + 8.
Middle Caps as Megacap Alternative
Middle capitalization (mid-cap) stocks are an area of the market less vulnerable to tax or regulatory risk, with better valuations and lower profit margins (more room for margin expansion). The bottom half of the S&P 500 is now equivalent to the "middle cap" part of the market. Investors can get exposure to these names via the equal-weight S&P 500, an alternative to the standard market-cap S&P 500 weighting.
The Equal Weight S&P 500 makes every S&P 500 component a 0.2% weight (100% / 500 companies), and currently Apple (AAPL), Microsoft (MSFT), and Nvidia (NVDA) are ~7% weights each in the S&P 500. Therefore, the equal weight index is underweighting these most valuable companies by a factor of about 35x. The bottom 200 components of the market-cap weighted S&P 500 are weighted at ~0.05% to ~0.02%, so equal weighting those components overweights those smaller companies by 4x to 10x. The effect of this to give the Equal Weight S&P 500 an extreme “mid cap” tilt. In fact, returns of the Equal Weight S&P 500 have almost exactly matched the S&P 400 Mid Cap in recent years. Efficient market believers should save the chart below. The components of the S&P 500 and the S&P 400 Mid Cap are completely different (though they are shuffled between these indexes when promoted or demoted to/from the S&P 500). The perfect correlation goes back even further as well.
S&P 500 Equal Weight (RSP) vs S&P 400 Midcap (SPMD) Total Returns last 5 years. (YCharts)
Invesco has the leading Equal Weight S&P 500 ETF in terms of AUM, with the Invesco S&P 500 Equal Weight ETF (RSP) having assets of $66B. Invesco recently launched a covered call version, the Invesco S&P 500 Equal Weight Income Advantage ETF (RSPA) on July 17, 2024. RSPA has only had 3 monthly dividends but is on pace for an annual 9.3% dividend yield if the average $0.40 monthly dividend is maintained going forward. RSPA could continue to attract interest and inflows as an alternative to the heavily megacap weighted JPMorgan Nasdaq 100 Premium Income (JEPQ) and Goldman Sachs S&P 500 Core Premium Income (GPIX) ETFs.
The relatively new Premium Income/Covered Call ETF space needs to build up a longer track record before it is more widely adopted. Ten years from now it could be the norm for retirees to have replaced some of their equity ETF allocations with Call Premium Income ETF versions.