Box Spreads and Cash Yield Tax Efficiency

Risk-free rates are currently rising significantly, and are probably positive at the moment on a real basis (after inflation, possibly after taxes as well at the moment).

For cash equivalents, I tend to focus on plain vanilla holdings such as pure T-Bills, or the closest thing to it, for their exemption from state income tax, risk-free status, and high liquidity.

A good money market fund for pure T-Bills is the Vanguard Treasury Money Market Fund, although it's not great, because it still has a minority of holdings that are not state tax exempt. But its low expense ratio and high asset level ensure efficiency and closely tracking yields to current T-Bill rates with the convenience of a fund.

Can You Do Better?

Yes, but.... risk (liquidity, counterparty, black swan, variance from market/strategy, etc.) is ever-present.

For example, several long-standing trading/market arbitrage strategies can partly be explained by the Black Scholes Merton model.

One such strategy is the box spread, which I'll explain further, encouraged by the recent introduction of a convenient new ETF tracking the strategy.

AlphaArchitect BOXX: A New Tax-Efficient Potential Cash Substitute

Investment innovation continues with the introduction of the AlphaArchitect BOXX: 1-3 Month Box Spread ETF. Designed as an alternative to traditional cash equivalents, this ETF centers around the concept of box spreads to earn cash yields with more tax efficiency.

Understanding the BOXX Strategy

BOXX employs an options trading strategy known as box spreads, which in theory should behave similar to the pricing/yield of other risk-free or low-risk cash equivalents. A box spread involves buying and selling both call and put options with the same expiry date but different strike prices. When executed correctly, the return from this setup mirrors the risk-free rate, akin to traditional cash equivalents, but with a critical difference – tax efficiency.

The Tax-Efficiency Advantage

The primary benefit of the strategy lies in its tax-efficient design. Box spreads, the foundation of this ETF, are classified by the IRS as section 1256 contracts. In this favorable treatment, 60% of gains are considered long-term capital gains, and the remaining 40% are short-term, irrespective of the holding period. This compares advantageously to the full income taxation applied to interest from bank deposits, T-bills, CDs, or taxable money market funds.

If you have tax loss carryforwards, this is a particularly compelling strategy, and can potentially compensate for what appears to be some early inefficiency with the fund not fully performing to its fullest expectations out of the gate. This is my own rationale for owning it, and I'd be less inclined to it right now without them, given the yield loss relative to other options at the moment.

Note on Risk

The AlphaArchitect BOXX ETF offers a novel approach to managing cash equivalents while aiming for better after-tax returns. However, like any investment, it comes with its risk and efficiency considerations. Investors should understand that box spread transactions, and therefore the BOXX ETF, may be subject to transaction costs and counterparty risk.

Counterparty risk is small, as the strategy is supposed to be limited to exchange-traded contracts, but it still theoretically exists. And there is no assurance that markets will always properly follow arbitrage pricing correctly at all times, as the financial crisis and other events have shown us during moments of duress.

Notes on Conflicts of Interest

I have no relationship with any strategy, investment advisor, or other financial institution named above. I do have a position in the BOXX ETF, and wrote about my own analysis herein based on this. Given the liquidity that should exist in the underlying assets it trades in, this conflict should not ever have a meaningful impact. A good analysis of this is the asset history of the ETF: check out large asset inflows/outflows and see what impact they had on the ETF's premium/discount and NAV over time.

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