NEOS Talks Tax-Efficient Approach to Options-Based Income ETFs

Income generation has been a big theme in the ETF market recently, but investor priorities have been shifting towards after-tax returns rather than focusing solely on top-line yields. That’s according to NEOS Investments co-founders Troy Cates and Garrett Paolella. Speaking in a recent webcast titled “Rethinking Tax-Efficient Income Generation,” they noted that in order to achieve better tax efficiency in income generation efforts, investors are turning more frequently to options-based strategies.  That demand has significantly expanded the segment of options-income ETFs in recent years. According to NEOS, the space has attracted $203.67 billion in inflows over the last three years and now encompasses more than 880 funds. “As we think about this space, it’s really about the quantitative approaches to deliver that yield enhanced or risk mitigated investment solution for the core areas of your portfolio,” said Paolella. “From an income perspective, the ability to leverage the options market, so call and put options and strategies, can help aid investors really in that income generation away from just their core traditional allocations.” As assets continue flowing in, advisors are also becoming more selective about how these products are built and how much income investors ultimately keep after taxes.Not All Options Are Created Equally The explosive growth of options-income ETFs has given advisors more ways than ever to generate portfolio income. However, it has also made fund selection considerably more complex. What began as a niche segment dominated by a handful of covered call strategies has evolved into a marketplace containing hundreds of products. They range from various combinations of index options, single-stock options, swaps, structured notes, and other derivatives. “When you look at a lot of the other types of option-based products, whether it’s swaps, equity linked notes, single stock options, or ETFs, you’re not always getting that full tax-efficiency, depending on the portfolio,” said Cates. As the category matures, advisors are increasingly evaluating how a fund generates income rather than focusing on the size of the distribution. Total return, tax efficiency, and long-term sustainability are becoming just as important as yield itself. “Its important to understand not only the investment strategy, the goals of the ETF and what it’s looking to achieve, the risks associated, but take it all the way a step further into tax efficiency,” Paolella added. “[You] tend not to have to do that in equities or fixed income, but that’s important here within looking at options-based strategies, because there are a lot of different tax efficiencies for each product, asset class etc., an important risk factor ultimately in your selection.” Why Tax Efficiency Is Moving to the Forefront For many investors, the appeal of options-income ETFs is straightforward: generate higher levels of cash flow without relying exclusively on dividends or bonds. While a double-digit distribution rate may appear attractive on paper, the portion ultimately retained by investors can vary significantly. This largely depends on how the income is taxed. Strategies that generate primarily ordinary income may create a very different after-tax outcome than those utilizing structures that can benefit from more favorable tax treatment.  “Here at NEOS there’s a lot of ways to gain tax efficiencies, and I think this [is] core to our overall belief because there’s different ways to achieve this, but if you’re investing in an income-oriented product, we think trying to keep the tax efficiencies top of mind is going to be the most fruitful for the end investor,” said Paolella. NEOS highlighted its use of index option contracts, which qualify for Section 1256 treatment. These contracts receive a blended 60% long-term and 40% short-term capital gains tax classification regardless of holding period.  “Some of the products we roll on a weekly basis, [and] some of them we roll on a monthly basis. So there’s always a realized gain or loss in the portfolio, whether that’s weekly or monthly, that we want to make sure to potentially be as tax efficient as possible just from that pure PNL standpoint,” Cates noted. “We also like 1256 contracts for a few other reasons, the liquidity, transparency they see in our portfolio. And of course, the contract size means we can treat fewer contracts, still get the same notional exposure, but not overload, you know, the portfolios with commissions and stuff like that.” After-Tax Outcome ToolsThe firm also discussed the role of tax-loss harvesting and return-of-capital distributions as tools that can potentially improve after-tax outcomes. “You might get qualified dividend income that passes through the ETF structure, which is a lower tax rate. You also might have, you’ll notice a lot of our portfolios hold US treasuries, and those interest payments, are exempt from state, local taxes. So it’s thinking that there’s actual tax efficient exposures, but a big part of it is the harvesting losses piece of it, and thinking about how you can convert a portion of the distribution going out to return of capital,” said Cates. “From an IRS perspective, if you can lower your cost basis and defer your taxes down the road, and have part of the distribution between the return of capital, that could be very tax advantageous for certain clients,” Cates added.Building Income Beyond Traditional Covered CallsOne of the more notable developments within the options ETF market is the expansion beyond traditional equity covered-call strategies. Early products largely focused on generating income from broad equity indexes such as the S&P 500 or NASDAQ 100. Today, options overlays are increasingly being applied across fixed income, commodities, real assets, and digital assets. NEOS has embraced that trend through an options-based lineup that spans equities, Treasuries, aggregate bonds, real estate, energy infrastructure, commodities, and crypto. The firm’s argument is that options overlays should be viewed as portfolio tools rather than standalone products.  Some of the notable standouts are the S&P 500 High Income ETF (SPYI A) which consists of core equity exposure combined with data-driven call overlay. Since inception, the fund has returned 70.79% with a distribution rate of 12.08%. On the fixed income side, the Enhanced Income 1-3 Month T-Bill ETF (CSHI ) has yielded a 22.49% since inception with a distribution rate of 4.70%. See more: VIDEO: ETF of the Week: CSHIThe Importance of Investor Due DiligenceAs the options-income ETF landscape continues to evolve, the distinction between high headline yield and true after-tax return becomes paramount. Investors and advisors alike must move beyond simplistic distribution rates and rigorously evaluate the structural tax advantages that can drive long-term outcomes. As the market expands with more complex products, the onus is on the investor to perform deep due diligence.  “The great thing about investing in ETFs is the transparency. You could go to the website of the advisor and pull up the holdings every night.” Cates noted.  By aligning tax-efficient strategies with broader portfolio goals, investors can better navigate this maturing segment to build more resilient, income-generating portfolios. As Paolella suggested, “Certainly do your research, understand the products.” For more news, information, and analysis, visit the Tax Efficient Income Content Hub.