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Behind the Curtain: ETF Distributions

Most ETFs are structured as Regulated Investment Companies, commonly referred to as RICs. As RICs, funds are required to distribute any taxable income to shareholders on an annual basis. As funds approach their fiscal year ends, gains and losses are calculated and a distribution amount is estimated and signed off on by the Fund’s Adviser. This distribution can comprise several elements, such as interest income, dividend income, long or short-term capital gains, and return of capital.

However, many ETFs pay more frequent distributions – such as quarterly, monthly (see YBTC), or even weekly (see QDTE and XDTE). By definition, funds that pay distributions more often than the annual requirement follow a different process because a Fund’s taxable income cannot be knowable (or properly estimated, really) until the full tax year is complete.

How are ETF Distributions Calculated?

At the highest level, there are two methods for determining ETF distribution payments, the first of which resembles the model employed by annual pay funds. In this process, an estimate is made to represent the taxable gain over a given period. For example, a Fund that is paying quarterly distributions might calculate an estimate of its year-to-date income to pay its first distribution at the end of March.

However, this process has potential drawbacks. For example, consider a dividend focused ETF with an underlying 4% annual yield. Let’s say the ETF has 1,000,000 shares outstanding and a Net Asset Value (“NAV”) of $10 to start the year (assets under management, or “AUM”, would equal $10,000,000). The first three months of the year pass and the ETF has received dividends of $100,000 from its holdings. Then, a creation order comes in for an additional 1,000,000 shares. While investors might expect to receive a payout of 1% of NAV for the first quarter, the number of shares outstanding increased to 2,000,000 which, at a NAV of $10, means the ETF’s AUM is $2,000,000. If the Fund Adviser were to pay on estimates alone, the ETF would only pay a 0.5% quarterly distribution ($100,000 in dividends divided by $20,000,000 AUM).

ETF Distributions Blog 1 5.14.24

Source: Roundhill Investments.

This is where the second method comes into play. In many cases, the Fund’s Adviser determines ETF distributions at their discretion. This can be formulaic, but there are no hard and fast rules as to what distribution an Adviser decides to pay.

For example, Roundhill uses an estimate of implied gross option premium to determine the monthly payout for our Roundhill Bitcoin Covered Call Strategy ETF. The same is true for our weekly pay ETFs, the Roundhill S&P 500 0DTE Covered Call Strategy ETF and Roundhill N-100 Covered Call Strategy ETF. By using the implied gross premiums, we do not account for gain/loss estimates to determine the payout figure. Instead, we return the gross premiums to shareholders, who in turn, can decide what to do with the cash – including reinvesting in the fund, investing in other funds, or anything else they may want to do.

Ex-Dividend – No Free Lunch

And the answer is always the same – Net Asset Value (NAV).

Regardless of whether a Fund’s strategy makes money or not on a total return basis, any distributions paid will reduce the Fund’s NAV. This is very simple, really. Prior to a distribution going ex-dividend, the Fund has the cash to pay the dividend inside the Fund. After it pays the dividend, the cash is in the hands of the shareholders. Therefore, the NAV of the ETF has decreased by the amount of the distribution. Some refer to this concept as “NAV erosion” when in excess of the Fund’s total return over a given period because the net result is a decrease in NAV per share. However, the NAV did not “erode”, it simply decreased by the distribution amount.

Understanding this concept is critical for investors involved in ETFs that pay meaningful distributions, including those in the Roundhill ETF lineup. 

At the highest level, investors in this type of ETF should ultimately pay attention to total return and associated risk. This is because regardless of whether a Fund pays a 1% annualized distribution or a 100% annualized distribution, the cash distributed to shareholders comes out of the Fund. The benefit of any distribution or dividend is not some sort of magic bullet to defy market gravity, but instead to return cash to shareholders that can then make their own decisions on what to do (i.e. reinvest in the fund, purchase other ETFs, pay their bills, etc.)

Annualized Distributions – What do they really mean?

Investors also need to properly grasp what distribution yield figures are meant to represent. For example, consider our Roundhill Bitcoin Covered Call ETF which recently published a distribution rate of 50.35% as of April 30, 2024. We calculate this figure by taking the most recently announced monthly distribution of $2.048398 per share and annualizing the figure by multiplying it by twelve (i.e. twelve months in the year). This is then divided into the month end NAV per share of $48.82.

We use this calculation method because it provides a “best estimate” rate based on currently available information. However, as with any forward-looking metric, it has potential drawbacks as a means to measure income potential.

Specifically, this common method for calculating distribution yield assumes a constant payout by annualizing the per share payout. Let’s use an example to illustrate potential drawbacks. Assume an ETF has a NAV of $100 and it just paid a monthly distribution of $1. Based on our calculation method, we would ascribe a distribution yield of 12% ($1 per share times 12 months divided into $100 NAV). Now let’s assume total return is flat over the course of the year – which of course we cannot predict ahead of time – and that the Adviser decides on a 1% payout each month. 

ETF Distributions Blog 2 5.14.24

Source: Roundhill Investments.

The table above shows how a zero total return coupled with a stable distribution rate results in a decreasing per share distribution over time. This example ties back to our earlier discussion. Ultimately, distributions are simply a transfer of funds from the Fund to shareholders. And this is not a bad thing (at all!) – in fact, the same is precisely true for dividend paying equities – but critically important to understand. 

Conclusion

In summary, ETF investors need to understand the mechanics of ETF distributions before considering an investment. As with everything in markets, there is no free lunch – but rather an exchange of risk. In the case of ETF distributions or stock dividends, risk is transferred out of the Fund or Company and into shareholders’ hands, who in turn make investment decisions.

Questions? Feel free to reach out to schedule a call at info@roundhillinvestments.com.

 

Investors should consider the investment objectives, risk, charges and expenses carefully before investing. For a prospectus or summary prospectus with this and other information about the ETF please call 1-877-220-7649 or visit the website at https://www.roundhillinvestments.com/etf/. Read the prospectus or summary prospectus carefully before investing.

All investing involves risk, including the risk of loss of principal. There is no guarantee the investment strategy will be successful. The funds faces numerous risks, including options risk, liquidity risk, market risk, cost of futures investment risk, clearing broker risk, commodity regulatory risk, futures contract risk, active management risk, active market risk, clearing broker risk, credit risk, derivatives risk, legislation and litigation risk, operational risk, trading issues risk, valuation risk and non-diversification risk. For a detailed list of fund risks see the prospectus.

Covered Call Strategy Risk. A covered call strategy involves writing (selling) covered call options in return for the receipt of premiums. The seller of the option gives up the opportunity to benefit from price increases in the underlying instrument above the exercise price of the options, but continues to bear the risk of underlying instrument price declines. The premiums received from the options may not be sufficient to offset any losses sustained from underlying instrument price declines, over time. As a result, the risks associated with writing covered call options may be similar to the risks associated with writing put options. Exchanges may suspend the trading of options during periods of abnormal market volatility. Suspension of trading may mean that an option seller is unable to sell options at a time that may be desirable or advantageous to do.

Flex Options Risk. The Fund will utilize FLEX Options issued and guaranteed for settlement by the Options Clearing Corporation (OCC). In the unlikely event that the OCC becomes insolvent or is otherwise unable to meet its settlement obligations, the Fund could suffer significant losses. Additionally, FLEX Options may be less liquid than standard options. In a less liquid market for the FLEX Options, the Fund may have difficulty closing out certain FLEX Options positions at desired times and prices. The values of FLEX Options do not increase or decrease at the same rate as the reference asset and may vary due to factors other than the price of reference asset.

YBTC

Bitcoin Futures ETF Risks. The Fund will have significant exposure to the Bitcoin Futures ETF through its options positions that utilize the Bitcoin Futures ETF as the reference asset. Accordingly, the Fund will subject to the risks of the Bitcoin Futures ETF, set forth below.

Bitcoin Risk. Bitcoin is a relatively new innovation and the market for bitcoin is subject to rapid price swings, changes and uncertainty. The further development of the Bitcoin network and the acceptance and use of bitcoin are subject to a variety of factors that are difficult to evaluate. The slowing, stopping or reversing of the development of the Bitcoin network or the acceptance of bitcoin may adversely affect the price of bitcoin. Bitcoin is subject to the risk of fraud, theft, manipulation or security failures, operational or other problems that impact the digital asset trading venues on which bitcoin trades. The Bitcoin blockchain may contain flaws that can be exploited by hackers. A significant portion of bitcoin is held by a small number of holders sometimes referred to as "whales." Transactions of these holders may influence the price of bitcoin.

Digital Asset Industry Risk. The digital asset industry is a new, speculative, and still-developing industry that faces many risks. In this emerging environment, events that are not directly related to the security or utility of the Ethereum blockchain or the Bitcoin blockchain can nonetheless precipitate a significant decline in the price of ether and bitcoin.

Digital Asset Regulatory Risk. Digital asset markets in the U.S. exist in a state of regulatory uncertainty, and adverse legislative or regulatory developments could significantly harm the value of bitcoin futures contracts or the Bitcoin Futures ETF's share, such as by banning, restricting or imposing onerous conditions or prohibitions on the use of bitcoin, mining activity, digital wallets, the provision of services related to trading and custodying digital assets, the operation of the Bitcoin network, or the digital asset markets generally. Such occurrences could also impair the Bitcoin Futures ETF's ability to meet its investment objective pursuant to its investment strategy.

New Fund Risk. The fund is new and has a limited operating history.

QDTE & XDTE

0DTE Options Risk. The Fund's use of zero days to expiration, known as "0DTE" options, presents additional risks. Due to the short time until their expiration, 0DTE options are more sensitive to sudden price movements and market volatility than options with more time until expiration. Because of this, the timing of trades utilizing 0DTE options becomes more critical. Although the Fund intends to enter into 0DTE options trades on market open, or shortly thereafter, even a slight delay in the execution of these trades can significantly impact the outcome of the trade. Such options may also suffer from low liquidity, making it more difficult for the Fund to enter into its positions each morning at desired prices. The bid-ask spreads on 0DTE options can be wider than with traditional options, increasing the Fund's transaction costs and negatively affecting its returns. Additionally, the proliferation of 0DTE options is relatively new and may therefore be subject to rule changes and operational frictions. To the extent that the OCC enacts new rules relating to 0DTE options that make it impractical or impossible for the Fund to utilize 0DTE options to effectuate its investment strategy, it may instead utilize options with the shortest remaining maturity available or it may utilize swap agreements to provide the desired exposure.

Roundhill Financial Inc. serves as the investment advisor. The Funds are distributed by Foreside Fund Services, LLC which is not affiliated with Roundhill Financial Inc., U.S. Bank, or any of their affiliates.

Glossary

Net Asset Value (NAV): Determined by subtracting the liabilities from the portfolio value of the fund's securities, and dividing that figure by the number of outstanding shares. NAV is a per share value.

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Carefully consider the investment objectives, risks, charges and expenses of Roundhill ETFs before investing. This and other information about each fund is contained in the Prospectus. Please read the prospectus carefully before investing as it explains the risks associated with investing in the ETFs.

These include risks related to investments in small and mid-capitalization companies, which may be more volatile and less liquid due to limited resources or product lines and more sensitive to economic factors. Funds investments may be non-diversified, meaning its assets may be concentrated in fewer individual holdings than a diversified fund and, therefore, more exposed to individual stock volatility than diversified funds. Investments in foreign securities involves social and political instability, market illiquidity, exchange-rate fluctuation, high volatility and limited regulation risks. Emerging markets involve different and greater risks, as they are smaller, less liquid and more volatile than more develop countries. Depositary Receipts involve risks similar to those associated with investments in foreign securities, but may not provide a return that corresponds precisely with that of the underlying shares. All investing involves risk, including possible loss of principal. Please see the prospectus for specific risks related to each fund.

NERD, BETZ, METV, DEEP, WEED, CHAT, MAGS, LUXX, LNGG, KNGS, YBTC, MAGQ and MAGX are distributed by Foreside Fund Services, LLC. DEEP is distributed by Quasar Distributors, LLC.

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