BOXX ETF

This post is for knowledge sharing only. It is not intended to be investment or tax advice.

BOXX ETF is a new financial product that offers nearly identical returns and risks to treasury bills, yet it may be more tax-efficient: 
  • You only have to pay capital gain tax on the shares you sell, not on all the savings you have.
  • If you hold onto the shares you sell for over a year, you'll pay the long-term capital gains tax, which is lower than the tax on both ordinary interest and treasury interest.
  • Sell shares within a year of buying them, and you'll pay short-term capital gains tax. It's the same rate as the tax rate of ordinary income but higher than the tax rate of treasury interest.

Heavy tax on interest

Every family should maintain some cash reserve as family emergency fund. The headache is that the interest generated from such cash reserve is taxed as ordinary income each year. For high income earners in California,
  • The tax rate on interest can be as high as 51% including 37% federal income tax, around 10% CA state income tax and nearly 4% net investment income tax.
  • Although treasury interest is exempted from state tax, the tax rate on treasury interest is still as high as 41% including 37% federal income tax and nearly 4% net investment income tax.
There is no way to defer the tax on interest except saving in series I saving bonds. See this post for some recent saving options of high interest rate.

BOXX tax efficiency to investors

BOXX ETF achieves the same return and risks as treasury bills by trading options on S&P 500 index. By carefully holding opposite positions of call and put SPX options (the so-called "box spread" strategy), BOXX gets a stable return that equals to the risk-free interest rate, no matter how the underlying S&P 500 index moves. In an efficient market, the risk-free interest equals to the annualized treasury interest rate.

The take home message to investors is that BOXX earnings are treated as capital gain rather than interest income, which are more tax efficient:

  • Tax deferral: there is NO tax on unrealized capital gains. In other words, investors only have to pay capital gain tax upon sale on the sold shares.
  • Low tax rate of long term capital gain: the highest tax rate on long term capital gain is 34% including around 10% CA state income tax and nearly 4% net investment income tax, which is lower than the total 51% tax rate on interest or the 41% tax rate on treasury interest. 
See this post for the details on the capital gain tax.

Remarks:

  • BOXX does not hold any treasury bonds! So there will be no interest income and thus one does not have to pay high tax on interest.
  • BOXX is NOT a bond ETF. So its price won't decrease as the interest rate raises. The price of BOXX is guaranteed to be monotonically increasing.
  • BOXX managers are trying their best to not distribute any gains or dividends to investors for the purpose of tax deferral. So far BOXX have not distributed any dividends.

BOXX innovations

Note that box spread is a well known strategy in option tradings to achieve a risk-free return. The true innovation of BOXX is to apply this strategy within a ETF and fully utilizes the tax advantages of ETF. Here is my understanding on how BOXX works:
  1. BOXX applies the box spread strategy and achieve a risk-free return. However, this alone is insufficient because any net gain in the ETF must be distributed to investors. BOXX still needs to find a way to create a paper loss to offset the gain from the box spread strategy.
  2. BOXX additionally holds two exact opposite option positions (a straddle). At the expiration, one position results in a gain while the other results in a loss.
  3. BOXX then exchange the winning position with an authorized participant (AP) to repurchase BOXX shares back from the market. This transaction belongs to the in-kind redemption and is tax-free within a ETF!
  4. BOXX retains the losing position and uses the realized loss to offset the gain from the “box spread” strategy.  

After these steps, there is no net gain. The BOXX price increases because the number of BOXX shares in the market decreases due to the redemption in step 3. 

BOXX risk

One of the biggest risk for BOXX ETF comes from the regulation. For example, an recent article argues that BOXX could violet some IRS tax provisions.

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