Digging Deeper: Return of Capital Distributions in ETFs

In our previous blog we discussed the basics of ETF distributions, including how amounts are calculated and their impact on a Fund’s Net Asset Value (NAV). In this post, we dive deeper into the tax characterization of ETF distributions, specifically focusing on the concept of “Return of Capital”.

What is Return of Capital?

As its name suggests, Return of Capital (“ROC”) is a tax characterization assigned to distributions that are not derived from specific investment gains, but instead paid out of principal. Specifically, ROC distributions are distributions in excess of a Fund's net investment income, the statutory distribution requirement for an ETF. If you recall from our previous blog, Regulated Investment Companies (“RICs”) must distribute any net investment gains to shareholders on an annual basis. 

Of course, net investment income is unknowable until the conclusion of a given tax year. Therefore, any interim ETF distributions rely on estimates for a breakdown of return of capital. Consequently, we are required to publish a Form 19-a notice to our website that estimates the breakdown for each distribution. We regularly publish these notices to our website to provide point-in-time estimates to shareholders (see QDTE as an example here).

The Funds currently expect, but do not guarantee, to make distributions on a monthly/weekly basis. These distributions may exceed the Fund’s income and gains for the Fund’s taxable year. Distributions in excess of the Fund’s current and accumulated earnings and profits will be treated as a return of capital. Distributions rates caused by unusually favorable market conditions may not be sustainable. Such conditions may not continue to exist and there should be no expectation that this performance may be repeated in the future. As of the most recent distributions by  the funds (QDTE, XDTE, and YBTC), the distribution composition was estimated to be 100% return of capital. Please see the 19a-1 notices for more information.

ROC With It

At first blush, the concept of Return of Capital might have investors asking themselves “why are they handing me money back?” Yet a closer examination reveals that return of capital may potentially offer benefits. 

1. Cash Flows Provide Optionality – ROC distributions can help investors manage their cash flow needs without needing to sell assets. Once capital is returned to shareholders, they can utilize it to fund living expenses, reinvest in the Fund, diversify in other assets, or anything else that they wish to do, providing ultimate optionality to shareholders.
2. Deferred Taxes* – Unlike distributions derived from net investment income, ROC distributions are not immediately taxable to end investors. Instead, they reduce a shareholder’s cost basis.
3. Generational Wealth Planning* – ROC distributions lower an investor’s cost basis, and as a result, no taxes are due until the Fund is sold. As with many other assets, however, the cost basis is stepped up to the market value upon a shareholder’s passing, allowing for potentially tax efficient generational planning.
4. Charitable Giving* – For individuals who make regular charitable donations, low-basis shares may offer tax efficiencies. So long as a fair market value is “readily available on an established security market”, the taxpayer can gift the shares to a charity and receive a deduction equal to the fair-market value of the shares. An ETF that pays ROC distributions will therefore return capital to shareholders resulting in a lowered cost basis whilst allowing for charitable donations at market value.

*Roundhill Investments and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only.

What’s the Catch?

In our opinion, there isn’t one, really. We believe most investors should prefer return of capital distributions to capital gains or dividend income, all else equal. However, investors need to understand that return of capital distributions, as with all distributions, reduce a Fund’s NAV. If a Fund pays distributions that are too high relative to the total returns earned by the Fund’s underlying strategy NAV will decrease over time.

Looking to learn more about ETF distributions? Check out our previous blog post on ETF basics and how they impact a Fund over time.

Not an offer: This document does not constitute advice or a recommendation or offer to sell or a solicitation to deal in any security or financial product. It is provided for information purposes only and on the understanding that the recipient has sufficient knowledge and experience to be able to understand and make their own evaluation of the proposals and services described herein, any risks associated therewith and any related legal, tax, accounting or other material considerations. To the extent that the reader has any questions regarding the applicability of any specific issue discussed above to their specific portfolio or situation, prospective investors are encouraged to contact 1-855-561-5728 or consult with the professional advisor of their choosing.

Forward-looking statements: Certain information contained herein constitutes “forward-looking statements,” which can be identified by the use of forward-looking terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “project,” “estimate,” “intend,” “continue,” or “believe,” or the negatives thereof or other variations thereon or comparable terminology. Due to various risks and uncertainties, actual events, results or actual performance may differ materially from those reflected or contemplated in such forward-looking statements. Nothing contained herein may be relied upon as a guarantee, promise, assurance or a representation as to the future.

Use of Third-party Information: Certain information contained herein has been obtained from third party sources and such information has not been independently verified by Roundhill Financial Inc. No representation, warranty, or undertaking, expressed or implied, is given to the accuracy or completeness of such information by Roundhill Financial Inc. or any other person. While such sources are believed to be reliable, Roundhill Financial Inc. does not assume any responsibility for the accuracy or completeness of such information. Roundhill Financial Inc. does not undertake any obligation to update the information contained herein as of any future date.

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.

Regulated Investment Company (RIC): A Regulated Investment Company (RIC) is a US corporation that acts as an investment agent for its shareholders and meets certain tax requirements.

Cost Basis: Cost basis is the original value of an asset for tax purposes, usually the purchase price, adjusted for stock splits, dividends, and return of capital distributions.