This is information rather than tax advice. Anyone holding these funds should review their position with qualified counsel.
- Goldman Sachs is buying boutique ETF provider Neos for as much as $2.25 billion, acquiring derivative-income funds whose two flagship vehicles have gathered $28 billion in four years within a $195 billion market for such products.
- The divergence between funds running comparable strategies is extraordinary. The Neos S and P 500 High Income ETF reported a return of capital rate of 94% in the last fiscal year, while Global X’s covered call fund on the same index reported 2.6%, because Global X makes a mixed straddle account election and Neos appears not to treat itself as in a straddle.
- Goldman’s own funds take the opposite view from the firm it is acquiring. The Goldman Sachs S and P 500 and Nasdaq-100 Premium Income ETFs, running $12 billion between them, consider themselves in straddle and recorded $135 million of straddle loss deferrals at the end of last year.
- The resulting outcome inverts normal tax logic. The Neos S and P 500 fund had a one-year tax cost ratio of 0.20% against 0.29% for the largest S and P 500 index tracker, meaning a fund making large regular distributions delivered a better after-tax result than one that only pays dividends.
What Happened?
These funds buy an index and sell call options on it, distributing the premium as income. In the JPMorgan version much of the payout is taxed as ordinary income, at 37% for top earners. The Neos funds classify most distributions as return of capital, which is not taxed on receipt but reduces the holder’s cost basis, deferring the liability until shares are sold and potentially taxing it at the 20% long-term rate. The straddle rule, dating from the early 1980s, prevents investors who are long and short the same securities from using losses on one leg to offset gains elsewhere, and bars treating dividends as qualified. JPMorgan, BlackRock and Morgan Stanley deliberately replicate only part of each index, with 70% overlap often treated as the limit, while Neos holds nearly all the constituents and classifies all dividends as qualified. Andie Kramer of ASKramer Law notes the code defines a straddle as a position causing substantial diminution of risk without defining that phrase, probably deliberately. Fordham law professor Jeffrey Colon said it is unclear how Neos treats all dividends as qualified given the stock positions and index options are clearly offsetting. Neos said derivative income funds vary significantly with no uniform practice, that it continually evaluates its approach and is guided by independent advisers. Goldman said its investment process is driven by what is best for clients.
Why It Matters?
The tax cost ratio comparison is the number advisers should sit with. A fund distributing substantial income every month produced a better after-tax outcome than a plain index fund that distributes only dividends. Under ordinary tax logic that should not occur, because distributions are taxable events and index funds exist partly to minimise them. It happens only because the distributions are largely not being taxed on receipt, which is the entire mechanism. That statistic is the clearest signal of how much of the return depends on a particular reading of the code rather than on investment performance. The Goldman contradiction is the detail that deserves most attention and the article leaves it implicit. Goldman’s own premium income funds treat themselves as being in straddle and have deferred $135 million of losses accordingly. It is now paying up to $2.25 billion for a firm whose funds reach the opposite conclusion on near-identical strategies. One of those positions will eventually be shown to be the correct reading, and the acquirer holds both. Investors should understand that the 94% against 2.6% gap is not a difference in skill, it is a difference in legal interpretation of a rule written before these products existed. The practical point for holders is that return of capital defers tax, it does not remove it. Each distribution reduces cost basis, and once basis reaches zero further distributions become immediately taxable. For a long-term holder receiving large payouts, basis exhaustion arrives on a schedule that can be modelled, and it should be. The guidance risk is live rather than theoretical. The IRS issued a notice on September 28 saying it is considering action on strategies that purport to produce results inconsistent with the proper application of federal tax rules, specifically including ETF tactics using the in-kind mechanism to avoid distributing ordinary income. Jeff McClean of Solidarity Wealth, a former tax attorney, describes a five to ten year runway before the IRS changes rules on structures operating in grey areas. Holders are collecting a benefit with a known expiry risk and an unknown expiry date.
What Next?
Watch for IRS guidance following the September 28 notice, since the in-kind mechanism is explicitly named and that is one of the two areas of disagreement here. The other, whether gains realised through creation and redemption should reduce return of capital, is quantified in the filings: one Neos fund realised $164 million of in-kind gains in six months while paying $412 million of return of capital, so the answer moves the figure substantially. The JPMorgan ROCY and ROCQ funds launched in March have gathered $1.5 billion with return of capital estimated above 90%, and their year-end figures will show whether active stock picking genuinely avoids straddle treatment. For advisers the immediate task is identifying which clients hold these funds, what their remaining cost basis is, and how the position would be affected if the tax character of distributions changed.
Affected Tickers and Coins: GS, JPM, BLK, MS
Source: Bloomberg
