BOXX: Cash-Alternative ETF, 5.6% Options Yield, Risks Abound #NewsETFs

I last covered the Alpha Architect 1-3 Month Box ETF (BATS:BOXX) in late 2023. In that article, I explained how BOXX achieves comparable returns to t-bills, and how it is able to retain generated income within the fund, allowing investors to defer any and all taxes until a moment of their choosing. Since then, the fund has achieved effectively identical returns to t-bills while making only one distribution. The fund broadly succeeded at its tasks, with higher after-tax returns for most investors.

Although I remain broadly bullish on BOXX, there are several negative issues investors need to consider. BOXX did make one distribution this year, so its strategy does not seem 100% effective, and changes to laws and regulations could always render 100% ineffective. Likely Federal Reserve cuts should lower t-bill rates, and hence BOXX returns. Higher-yielding alternatives would become stronger, even after accounting for BOXX’s tax benefits. Overall, BOXX remains a solid fund, but definitely worse than before.

BOXX – Quick Overview

A quick explanation of how the fund works before looking at some more recent developments. BOXX has a fantastic primer here, I have a longer explanation here.

BOXX buys and sells monthly equity options. Positions are offset so that price risk or exposure is zero. Conceptually, a monthly investment with (approximately) no risk is equivalent to investing in t-bills, so returns should be extremely similar. Returns have been effectively identical since inception, broadly in-line with expectations.

ETFs must generally distribute any and all income generated to investors, including t-bill income. Exceptions are few and far between. Option profits are a different matter, with ETFs being sometimes able to retain these, depending on specifics. Since inception in late 2022, BOXX has paid one distribution, so it does seem to be generally able to retain option profits, but not always.

Due to the above, BOXX provides some potential tax advantages to investors.

Insofar as the fund is able to avoid distributions, investors are able to defer any and all taxes until a moment of their choosing. Investors might be able to time their sales so as to minimize their tax burden, depending on their circumstances.

BOXX’s options are classified as 1256 contracts, meaning 60% of their gains are taxed at long-term capital gains rates, and 40% are taxed at short-term capital gains rates. Long-term capital gain tax rates tend to be comparatively low, which might allow some investors to reduce their tax burden.

BOXX achieves comparable returns to t-bills before tax, higher after-tax returns. For some investors at least.

Overall, BOXX is a solid choice, but there are a couple of risks and issues here investors need to be aware of. Let’s have a look at these.

BOXX – Risks and Issues

Strategy Not 100% Effective

BOXX aims for zero distributions each year. It has paid one distribution this year, last week. Although the fund’s strategy is generally effective, it is not 100% effective, an obvious negative.

It is effectively impossible for outside investors to predict the number or timing of any future distributions for the fund, another negative. BOXX should still offer significant tax advantages to t -bills for many investors, but these seem a bit weaker now than before.

Section 1258

BOXX’s potential tax advantages could change, or be eliminated, by changes in applicable regulations and laws. Kamala Harris is calling for a tax on unrealized capital gains for high net worth individuals. Although this specific tax, as envisioned, would not impact the vast majority of investors, proposals could always change.

In my opinion, capital gains tax hikes are the likeliest risk for BOXX in this regard. Nevertheless, I would feel negligent not mentioning another risk, centered on an older tax law targeting similar spreads to those used by BOXX.

Daniel Hemel, a professor of law at New York University School of Law, wrote a pretty convincing article arguing that Section 1258 of the Internal Revenue Code calls for classifying BOXX’s box spreads as taxable income. Simplifying things a tonprofits from certain straddles are classified as income, as are profits from transactions marketed as producing capital gains from the expected return on the time value of money.

At first glance, it seems like BOXX’s spreads classify, with three caveats.

First, it seems that 1256 contracts are exempted from the above, with BOXX focusing on these. Hemel argues against this, but I was not fully convinced.

Second, it does not seem like BOXX is marketing itself as producing capital gains from the expected return on the time value of money. Their explanation on the fund focuses on arbitrage and market efficiency, and barely touches on these issues.

Third, ETFs are generally able to defer capital gain taxes / realizing gains with their creation and redemption mechanism. BOXX could, perhaps, run it strategy through this. At the same time, the IRS seems content letting ETFs defer taxes through these mechanisms, so other strategies could easily work too. The precedent is clear, and favorable to BOXX.

BOXX’s spreads do seem fine, in my opinion at least. I’m far from a tax expert, though, and obviously the IRS could end up thinking otherwise.

More broadly, BOXX’s tax advantages are dependent on specific laws, regulations, even government guidance. These could change, reducing or eliminating BOXX’s advantages. Something to consider.

Likely Federal Reserve Cuts

BOXX’s returns closely track t-bill rates, which, in turn, closely track Fed rates. As the Federal Reserve cuts rates later in the year, BOXX’s returns should decrease as well.

The above is a significant, straightforward negative for BOXX and its investors. On a more positive note, current Fed guidance calls for relatively slow-paced cuts, so returns should remain relatively good for a couple of years.

Federal Reserve cuts would also diminish BOXX’s tax advantages, making higher-yielding alternatives better for some investors. This is easier to show with an example.

Right now, BOXX’s underlying holdings have expected returns of 5.4%. Subtract the 0.21% in expenses, and expected returns for the fund are 5.2%, broadly in-line with Fed rates. BOXX generally trades with a slight spread to these, and did so as recently as two weeks ago, when this article was first published in the CEF / ETF Income Laboratory.

The Janus Henderson AAA CLO ETF (JAAA), somewhat comparable to BOXX, has an SEC yield of 6.7%, around 1.5% higher than BOXX.

BOXX must provide 22% in tax benefits to have a higher after-tax return than JAAA. Assuming BOXX investors pay 15% in capital gains, JAAA’s investors need to pay 36% in Federal Income tax for BOXX to break-even. Investors in the highest tax bracket pay 37%, a bit more. For these investors, BOXX provides higher after-tax yields. BOXX’s investors can defer their taxes too, another benefit not captured in these figures. As a small aside, spreads have been generally tighter between BOXX and JAAA, so the former has generally provided higher after-tax yields for more investors than seems to be the case right now.

Federal Reserve cuts change the calculation.

Let’s say the Fed cuts the rate by 5.0%. BOXX’s returns would plummet to around 0.2%, JAAA’s SEC yield would go down to 1.7%. In that case, BOXX would have to provide around 89% in tax benefits to have a higher after-tax return than JAAA. Taxes are simply not that high, so JAAA would be the better choice for basically 100% of investors if the Fed were to slash rates.

As the Federal Reserve cuts rates, spreads start to matter more and more, tax benefits less and less. Expected Federal Reserve cuts put the fund in something of a difficult spot, in which some investors might get some benefit from the fund, others would be better off focusing on higher-yielding taxable choices, including JAAA.

Considering the above, I believe BOXX’s investors should take another look at the fund as the Federal Reserve cuts rates later in the year. For some, the fund will cease to provide higher after-tax returns than its peers in the coming months.

Conclusion

BOXX uses box spreads, an options strategy, to achieve comparable returns to t-bills, at similar risk and volatility. Although I remain bullish on the fund, it is facing several important headwinds, Federal Reserve cuts chief among these. The fund remains a solid choice, but returns should decrease in the coming months and years.