BOXX: Alternative Cash ETF, 5.6% Option Yield, Abundant Risk

Last time we covered the Alpha Architect 1-3 Month Box ETF (BATS: BOXX) at the end of 2023. In that article, I explained how BOXX achieves comparable T-bill returns and how it is able to retain the revenue generated in fund, allowing investors to defer all taxes until a time of their choosing. Since then, the fund has achieved identical effective returns on government securities by making a single distribution. The fund generally succeeded in its tasks, with higher after-tax returns for most investors.

While I remain generally bullish on BOXX, there are some downsides that investors need to consider. BOXX did one distribution this year, so his strategy doesn’t seem 100% effective, and changes in laws and regulations could always make it 100% ineffective. Federal Reserve tapering should probably lower Treasury rates and therefore BOXX will return. Higher-yielding alternatives would become stronger, even after accounting for BOXX 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 stock options. Positions are offset so that price risk or exposure is zero. Conceptually, a monthly investment with (roughly) no risk is equivalent to investing in T-bills, so the returns should be extremely similar. Returns were effectively identical from the start, largely in line with expectations.

ETFs must generally distribute any and all income generated to investors, including income from government securities. Exceptions are few and far between. Options profits are a different matter, ETFs being sometimes able to retain them, depending on the specifics. Since inception at the end of 2022, BOXX has only paid one distribution, so it appears to be generally able to retain option profits, but not always.

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

To the extent that the fund can avoid distributions, investors can defer all taxes until a time of their choosing. Investors may be able to time their sales to minimize their tax burden, depending on their circumstances.

BOXX 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 gains tax rates tend to be comparatively low, which could allow some investors to reduce their tax burden.

BOXX makes comparable returns to government bonds before tax, higher returns after tax. At least for some investors.

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

BOXX – Risks and Issues

The strategy is not 100% effective

BOXX aims for zero distributions every year. He paid a 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 government bonds for many investors, but they look a bit weaker now than before.

Section 1258

The potential tax benefits of BOXX could be modified or eliminated by changes in applicable regulations and laws. Kamala Harris calls for an unrealized capital gains tax on high net worth individuals. Although this specific tax, as expected, would not affect the vast majority of investors, the proposals could always change.

In my opinion, the increase in capital gains tax is the most likely risk for BOXX in this regard. However, I would be remiss not to mention another risk, centered on an older tax law targeting spreads similar to those used by BOXX.

Daniel Hemel, a law professor at New York University School of Law, has written a fairly compelling article arguing that Section 1258 of the Internal Revenue Code requires BOXX’s box spreads to be classified as taxable income. Simplifying things a tonprofits from certain pieces are classified as income, as are profits from traded transactions as producing capital gains from the expected return on the time value of money.

At first glance, BOXX’s spreads appear to qualify, with three caveats.

First, it appears that 1256 contracts are exempt from the above, with BOXX focusing on them. Hemel argues against this, but I wasn’t entirely convinced.

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

Third, ETFs are generally able to defer capital gains/gains realization taxes through their creation and redemption mechanism. BOXX could probably play their strategy through this. At the same time, the IRS seems content to let ETFs defer taxes these mechanisms, so other strategies could easily work as well. The precedent is clear and favorable to BOXX.

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

More broadly, BOXX’s tax advantages depend on specific laws, regulations, even government guidance. They may change, reducing or eliminating the benefits of BOXX. Something to consider.

Probably cuts by the Federal Reserve

BOXX’s yields closely track Treasury rates, which in turn closely track Fed rates. As the Federal Reserve cuts rates later in the year, BOXX yields should also decline.

The above are significant and direct negatives for BOXX and its investors. On a more positive note, the Fed’s current guidance calls for relatively slow tapering, so it’s coming back should remains relatively good for several years.

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

At this time, BOXX’s core holdings expected returns of 5.4%. Subtract 0.21% from expenses, and expected returns for the fund are 5.2%, broadly in line with Fed rates. BOXX generally trades at 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 Lab.

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

BOXX needs to offer 22% tax benefits to have a higher after-tax return than JAAA. Assuming BOXX investors pay 15% of capital gains, JAAA investors must pay 36% in federal income tax for BOXX to break even. Investors in the highest tax bracket pay 37%, slightly more. For these investors, BOXX offers higher after-tax returns. BOXX investors can also defer their taxes, another benefit not captured in these numbers. As a side note, spreads were generally tighter between BOXX and JAAA, so the former generally offered higher after-tax returns for more investors than appears to be the case now.

Federal Reserve cuts change the calculus.

Suppose the Fed cuts the rate by 5.0%. BOXX’s yields would drop to about 0.2%, JAAA’s SEC yield would drop to 1.7%. In this case, BOXX would have to offer about 89% of tax benefits to have a higher after-tax return than JAAA. The fees just aren’t that high, so JAAA would be the better choice for virtually 100% of investors if the Fed were to cut rates.

As the Federal Reserve cuts rates, spreads matter more and more, tax benefits less. Expected cuts by the Federal Reserve have put the fund in a tough spot, where some investors could receive some benefit from the fund, others would be better off focusing on higher yielding taxable options including JAAA.

Given the above, I think 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 stop offering after-tax returns higher than peers in the coming months.

Conclusion

BOXX uses the box spread, an options strategy, to achieve comparable returns on government securities with similar risk and volatility. While I remain bullish on the fund, it faces several significant headwinds, the Federal Reserve reducing it among them. The fund remains a solid pick, but returns should decline in the coming months and years.