BOXX ETF: Cashlike Returns Without the Tax Bill

Margaret Giles: Welcome to Investing Insights. I’m Margaret Giles, content development editor for Morningstar, Inc. More investors are thinking about cash as an investment thanks to higher cash yields. But those tempting yields can come with big tax bills. Can investors have their cash and keep it, too?

An exchange-traded fund launched in December 2022 aims to make that happen. Manager Research Analyst Lan Tran, with Morningstar Research Services, is here to explain the ins and outs of the Alpha Architect 1-3 Month Box ETF known as BOXX. Here’s our conversation.

Thanks for being here, Lan.

Lan Anh Tran: Thanks for having me.

What Makes BOXX ETF Stand Out

Giles: All right. So, the BOXX ETF when it launched in December got a lot of attention. Can you explain why it was created and what makes it stand out?

Tran: Yeah, the fund has definitely grown a lot recently, and I think the main appeal really is tax. And so, the way that BOXX is set up is advantageous from a tax perspective. What it’s trying to do is to give you the return of a 1-3-month Treasury bill, what we would consider broadly the risk-free rate or the cash yield rate, but without the interest income the Treasury bill would pay out. And so, if you hold a Treasury bill, you get the interest income when the Treasury bill matures and also, as you mentioned, the tax bill. And so that’s getting taxed at the ordinary income tax rate, which is pretty high, and your tax bill can be pretty hefty. When you hold BOXX and it’s not paying out anything, your tax bill only really comes when you decide to sell the funds, and that’s getting taxed as capital gains. If you hold the fund for longer than a year, that’s long-term capital gains. And so that is going to be lower than the ordinary income tax rate for most tax brackets. And that’s not an easy thing to do. Otherwise, more people would have done it. But it’s also not a new or novel concept. The fund uses a very popular option trade called “box spread,” hence the ticker, BOXX. And that’s been around for a while. They just managed to figure out how to package it inside an ETF.

What Is a Box Spread?

Giles: Got it. So, you mentioned that box spread. Can you explain what that is and how it works in a little more detail?

Tran: For sure. And I will try to keep it as simple as possible. So, bear with me here for a second. A box spread is a combination of four options positions with the same expiration date. What you really need to know about it is just that it behaves like a zero-coupon bond when the options are all combined. And what do I mean by that? So, let’s consider, say, a box spread on the S&P 500, with options using the S&P 500. And so, the payout for that box spread, what you get when those all four options expire, is predetermined. It’s a constant fixed amount that you will always get regardless of what happens to the S&P 500. And so that’s like the coupon bond because then the price you pay for the box at the beginning determines your rate of return. So, similar to a zero-coupon bond, that’s a predetermined part you get at the end, you buy a discount at the beginning. And the difference is your rate of return.

So why do we say that that rate of return is similar to the cash yield or the risk-free rate? And that’s because you get—for any investment really—the return you get is compensation for the risk that you take. And here you’re not taking on a whole lot of risk. We were talking about how you don’t have really any equity risk because the payout is the same regardless of what happens to the S&P 500. You’re not taking on early assignment risk, which is an issue with box spread in general, but not an issue with BOXX, the fund, because the managers are using European style options. Those cannot be assigned or exercised early. You’re also not taking on a whole lot of counterparty or credit risk because, BOXX, the fund, is using exchange-traded options that are centrally clear by the Options Clearing Corp., the OCC. And so, really the only thing you’re getting exposure to is a sort of interest-rate risk, the duration risk, of the duration of the box. And in this case, it’s very short. It’s one to three months. And so, you’re getting 1-3-month Treasury bill return.

Tax Advantages

Giles: Interesting. That certainly is complicated. So, you touched on this already, but the main appeal of this fund is the tax savings. Can you talk about that again? How does the strategy deliver tax savings to investors?

Tran: Yeah, that’s an important question. And again, a little bit of simplification here because the actual tax code is a bit more complicated. But there are two main reasons for that. The first one is that ETF, the ETF structure is more tax-efficient than the mutual fund structure. And the second reason is that the way that BOXX is set up. It’s set up as option in a way that lets it take advantage of that ETF structure. And so why is an ETF more tax-efficient than a mutual fund? It’s because of this thing called an in-kind transaction. And so, when you sell a mutual fund, you go to the fund manager and the fund manager sells some stocks. They get some cash. They give your money back, but they realize capital gain after they sell the stock. And so that’s not optimal, right? Because it’s taxable. When you sell an ETF share, you’re not trading with the manager. You’re trading with an authorized participant, which are institutions that are specifically designated to handle market trades for an ETF. And so, the authorized participant goes to the ETF portfolio manager. They say, “Hey, I have some ETF shares. Get me a basket of your stock that is worth the same amount as these shares.” And so, in reality, what they do is just swapping some shares, hence in-kind moniker. And so, they actually haven’t dealt in cash at all. And so that’s not taxable.

So, the thing is, though, not everything can be in-kind, right? So, there are restriction, obviously, and we will get into that. But just know that options on stock and ETF can be in-kind. A little bit of history background: In 2017, the SEC allowed a fund manager to do that. And that’s precedent, and we operate on a precedent basis. So that’s that. But what does BOXX hold? A lot of box spread on SPY, which is the SPDR, S&P500 ETF Trust, which is an ETF trust. But those are in-kindable. They also can sometime hold a box spread on single stock that they can use to harvest loss to offset any potential capital gain that they might get throughout the course of operating the fund. But either way, both of those options are in-kindable. And so, I think, if you look at the history of the fund, you might notice that they use the whole options on the S&P 500 index itself, SPX option. As the fund had scaled, they’ve been able to use SPY option. And so, index option is a whole another topic and different tax treatment. They had to do other things to make it work, but either way, now they use SPY options, that’s in-kindable.

Is BOXX ETF Delivering on Its Promises?

Giles: Got you. I feel like we’re just getting into more and more complicated, but if I understand correctly, the timing of this maybe becomes a little bit important about when they’re putting on these options. So overall, is BOXX delivering on its promises? Has it been able to keep the tax bill low and deliver the returns that it says it will?

Tran: Yeah. So, returnwise, it’s been close to the 1-3-month Treasury bill return. Payoutwise, even as I mentioned that they previously used index option, which is more complicated, actually, since inception, they haven’t paid out any taxable distribution. No dividend, no capital gain, no return on capital, or anything since inception in December 2022, which is its own caveat because that’s a short track record. It’s about a year-and-a-half at this point. And so, we still have to keep an eye on the fund, how the managers are implementing the strategy, and any potential operational or legal hiccup. But yeah, so far so good.

Will the BOXX ETF Attract Investors If Cash Yields Drop?

Giles: All right. Cash yields are currently high thanks to an inverted yield curve, and BOXX has passed $3 billion, I believe, in assets since it launched. Do you think the ETF will continue to attract investors even if cash yields drop?

Tran: Yeah, I do agree that some of the appeal has been because of how high cash yield has been. But I do think that tax is always top of mind for investor, A, and B, people always do need to hold some cash, whether it’s an emergency fund, or if it’s a short-term liquidity need, a big purchase, or even, behaviorally, if they are trying to have a small buffer of cash for market volatility. We can talk on a different day about whether they should do that or not. But regardless of what it is, people do need cash. And I don’t think that appeal would be completely gone after the Fed cuts rates, whenever that might be.

How Investors Can Take Advantage of BOXX ETF

Giles: Got it. So how can investors properly take advantage of what this ETF has to offer?

Tran: Yeah. So again, the main draw is tax. So, investor in a tax-deferred account or any tax-deferred account that you might have is not going to benefit from this. But if you are looking to harvest cash yield in a taxable account, you consider this alongside a traditional money market fund. I would say, we throw around the term cash today a lot and also just in investment in general, but there are differences between like paper moneys in your bank and cashlike instruments. So, from your deposit to a CD that’s FDIC-insured or T-bills or money market fund to something like this, like BOXX, the more complex you get, the more marginal risks there are. And so obviously, be aware of what you’re getting into and the risks involved with that. The prospectus of the fund is long but do read it. It’s there for a reason. And so yeah, just keep an eye on your investments as they evolve.

Giles: So, it feels like first thing is just do your due diligence, perhaps?

Tran: Yeah.

Will There Be More ETFs Like BOXX?

Giles: Do you anticipate any other ETFs following in BOXX’s footsteps? Or is it going to remain unique in the market?

Tran: That’s a million-dollar question. I would say the investment strategy itself is not complicated. It’s, as I mentioned, is a popular options trade. People have been doing it for a long time. The managers are not trying to add anything fancy to it. They’re not trying to find mispriced box. So, they’re not trying to get alpha from it. They’re just trying to get the risk-free rate. So, in terms of investment strategy, it’s not hard to replicate. But there’s always the challenge on the operational and legal side of thing, especially with something as complicated as this is going to be a hassle to set up. And so, we’ll keep an eye out on the space to see. But yeah, we will not be surprised if someone else tried to do the same thing.

Key Takeaways

Giles: Got it. So, to finish up, what’s the key takeaway you have about this ETF, and is it worth the hype?

Tran: The first takeaway is that the investment strategy works. The concept of box spread works. It’s been around for a while. It just a way to get you the risk-free rate. That’s like getting T-bills but without associated interest income. The other takeaway is that from a payout, from a tax perspective, I mentioned so far so good, the fund has not paid out any kind of taxable gains so far. The options that it use is able to in kind within an ETF wrapper. So, they’re allowed to do that. But we also, the caveat is that the tax code is complicated. We don’t have a crystal ball into the future or what the tax authority is thinking. So, we’ll continue to keep an eye out on that. I wouldn’t evaluate if it’s worth the hype or not. I think the ETF has been getting a lot of traction, especially for a smaller issuer. But I do think it’s doing what it says that it would do.

Giles: All right. That’s good to know. Well, Lan, thanks for taking the time to explain a lot of complicated issues and how this interesting kind of unique ETF works.

Tran: For sure. Thanks for having me.

Giles: That wraps up this week’s episode. Subscribe to Morningstar’s YouTube channel to see new videos about investment ideas, market trends, and analyst insights. Thanks to Senior Video Producer Jake VanKersen, Lead Multimedia Editor Ivanna Hampton, and Associate Multimedia Editor Jessica Bebel. And thank you for watching Investing Insights. I’m Margaret Giles, content development editor at Morningstar.