Options-Based ETF Expert Explains ETF Construction, Pros And Cons, Tax Treatment And Roles In A Portfolio
Many of us remember a childhood spent adjusting rabbit-ear antennas on large television sets with small screens just to receive four or five channels through the airwaves. The advent of cable brought dozens of channels, and now we have practically endless on-demand programming at low subscription rates.
ETFs have evolved in the same way. Gone are the days when investors marveled at “spiders,” “diamonds” and other index trackers. With modern technology and financial engineering, ETFs can accomplish almost anything managers and investors can imagine, and in the past decade ETFs with options-based strategies emerged on the scene.
Propelled forward by the uncertain traditional markets of 2022, some advisors have adopted options-based ETFs into their portfolio-construction toolkits or are considering doing so.
With over 24 years of experience trading and managing portfolios, Troy Cates co-founded NEOS Investments in May of this year to provide advisors and their clients with various options-based ETFs combining traditional underlying assets with enhanced yield-generating options strategies.
Cates now serves as Co-Founder and Managing Partner at NEOS, as well as Managing Director, Portfolio Manager at Harvest Volatility Management, where he helps manage the firm’s institutional portfolios and ETFs while guiding the development of its exchange traded products.
We asked Cates about the pros and cons of options-based ETFs, their tax treatment and how they fit in a portfolio.
WSR: Briefly describe options-based ETFs.
Cates: An options-based ETF is a publicly traded investment fund that utilizes options trading to either provide exposure to certain securities or seek an alternative outcome compared to what would be achieved from investing directly in only the underlying securities.
It’s best practice for firms creating options-based ETFs to integrate quantitative methods with an understanding of volatility, risk management and market insights, to provide clients with better strategies.
In addition, well-constructed options-based ETFs offer core portfolio exposure with an added layer of tax-efficient monthly income generation potential.
WSR: What are the pros and cons of options-based ETFs?
Cates: Not all options-based ETFs are created equally and many only provide a one-dimensional solution such as the potential for income generation or downside risk mitigation.
Advisors should look for ETFs constructed according to the best practices mentioned above. In addition, options-based ETFs should be able to serve as a complement or alternative to traditional income-oriented investments in many investor portfolios. The products we offer follow these recommendations.
WSR: What tax issues should advisors research when choosing options-based ETFs to help clients with tax planning?
Cates: Advisors should understand the sources that generate their portfolio income. For example, ETF options are treated differently for tax purposes than equity index options. Index options are unique in that the IRS considers them “section 1256 contracts” and grants them 60% long-term / 40% short-term tax treatment, resulting in lower taxes.
With that said, we always recommend consulting a tax advisor because every individual’s situation is unique.
WSR: How would an advisor use options-based ETFs in a client portfolio? What clients are they suitable for?
Cates: Options-based ETFs can serve as useful portfolio building blocks for investors looking to generate additional income from their core investment allocations, or for those looking to diversify their current income portfolios.
Michael Madden, Contributing Editor & Research Analyst at Wealth Solutions Report, can be reached at firstname.lastname@example.org