The Next Evolution: Introducing Managed Distribution ETFs
Since the introduction of the “ETF Rule” in 2019, actively-managed ETFs using options, swaps, and other derivatives have exploded in popularity. Amongst this group of ETFs, two notable product segments have emerged.
The first, often referred to as “buffer” or “defined outcome” funds, aims to provide distinct payoff structures akin to structured products (i.e. limited downside in exchange for limited upside). The second segment can broadly be defined as “premium income” strategies, whereby option overlay strategies (i.e. covered call, put write, etc.) are packaged into ETFs and income is distributed to fund shareholders.
Nearly all premium income funds, our covered call ETFs included (see: QDTE, XDTE, RDTE, YBTC, and YETH), achieve their investment objectives by selling options (i.e. collecting premium). Consequently, the total return offered by these funds may substantially differ from the underlying reference asset depending on the market environment. Specifically, this occurs because any systematic options overlay strategy will, definitionally, generate profits or losses. Over time, these trading profits or losses can become meaningful, and in turn, result in substantial outperformance (in the case of profits) or underperformance (in the case of losses) when compared to the benchmark. As an example, our recent blog post highlights how QDTE outperformed QQQ (and various peers) since its launch through September 30th.
So what’s the solution for investors looking for “market-like” returns coupled with the potential for substantial distribution payments?
Enter Target Managed Distributions
In order to meet this unmet demand, Roundhill Investments is excited to announce the launch of the Roundhill S&P 500 Target 20 Managed Distribution ETF (NYSE Arca: XPAY), which is now live and available for trading. Additionally, the Roundhill S&P 500 Target 10 Managed Distribution ETF (NYSE Arca: SPAY) has filed its effective registration statement and is expected to launch for trading in the coming months.
We believe XPAY and SPAY offer an alternative to premium income ETFs, while providing the potential for total returns roughly equal to the S&P 500 Index over time. These strategies transform the total return stream offered by their underlying index in order to generate greater, and more consistent, income.
Let’s explore how they work.
Return of capital represents a return of a portion of a Fund shareholder’s invested capital and is not taxable in the year it is received unless the distribution exceeds a shareholder’s basis in the Fund. However, a return of capital may result in an increase in a later gain on a sale of Fund Shares or a reduction of a loss.
The strategy targets those investors who seek monthly income from their investment but wish to retain exposure to the return of the S&P 500® Index. Because a significant portion of the Fund’s distributions will consist of return of capital, the Fund may not be an appropriate investment for investors who do not want their principal investment in the Fund to decrease over time or who do not wish to receive return of capital in a given period.
S&P 500 Exposure
SPAY and XPAY both seek to replicate the total return of the S&P 500 by primarily investing in deeply-in-the-money call options on the ETFs that seek to track the performance of the S&P 500 Index.
Specifically, the Funds both intend to hold European-style call options with strike prices very close to zero (i.e. $0.01) that function very similarly to a traditional long stock position. Furthermore, both funds target notional exposure of 100% of NAV and don’t hold any other risk positions (long or short).
As a result, SPAY and XPAY are likely to generally track the performance of the S&P 500, and therefore might be considered as replacements for existing large cap U.S. equity exposure.
But why should anyone consider a replacement?
Managed Distributions
As their names suggest, SPAY and XPAY are designed to pay regular “managed” distributions to shareholders.
XPAY is designed to pay monthly managed distributions at an annualized rate of twenty percent (20%). Specifically, the monthly per share distribution amount will be determined at the start of each year based on prior year-end NAV. For example, if XPAY ends 2024 at a NAV of $50.00 per share, then the monthly payouts for 2025 would each be approximately 83.3 cents, calculated as follows:
12/31/2024 Net Asset Value (NAV) of $50.00 * 20% = $10.00 annual distribution
$10.00 annual distribution / twelve months = $0.833333 monthly distribution
Since the ETF distributions are “managed” to achieve precise payouts, SPAY and XPAY distributions will not vary month-to-month. Instead, the Funds are designed to provide predictable cash flow streams to investors, who can in turn use the ETF distributions to fund their expenses or use for any other purpose they see fit.
As a result, SPAY and XPAY may be attractive alternatives for investors that regularly sell down equity exposure or otherwise rely on taxable income generated from their investments to fund their living expenses. For example, reducing existing equity exposure requires open market sales, and potentially capital gains, to generate cash.
For retirees that prefer maintaining equity exposure over increasing their fixed income exposure, Roundhill Managed Distribution ETFs might be a fit for their portfolios.
Return of Capital
By using derivative exposure to replicate a long S&P 500 position, SPAY and XPAY are designed to maximize return of capital treatment for their distribution payments.
Return of capital distributions result in a lowered cost basis for shareholders, and do not result in taxes due in the year in which they are received.
Therefore, SPAY and XPAY may be optimal for investors that seek current income, but wish to retain exposure to the S&P 500. Specifically, retirement-age and income-seeking investors might want to stay invested in equities for generational wealth planning purposes.
SPAY and XPAY fill this need while providing near term income that is not immediately taxable, unlike alternatives such as fixed income, which produces taxable income in the year in which coupons are received.
Summary
To summarize why Roundhill Managed Distribution ETFs might be a fit for your portfolio:
- Core exposure – SPAY and XPAY both offer exposure to the S&P 500 as an underlying reference asset.
- Managed distributions – SPAY and XPAY are designed to provide monthly distributions to shareholders well in excess of the S&P 500’s dividend yield.
- Return of capital – SPAY and XPAY use active management to target return of capital distributions, which may provide various tax deferral benefits.
Investors should consider the investment objectives, risk, charges and expenses carefully before investing. For a prospectus or summary prospectus with this and other information please call 1-855-561-5728 or visit the website at https:// www.roundhillinvestments.com/etf/. Read the prospectus or summary prospectus carefully before investing.
Distribution Tax Risk. The Fund currently expects to make distributions on a monthly basis. These distributions are expected and designed to 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. The Fund seeks to be managed such that the entirety of the Fund’s distributions will be treated as a return of capital. A return of capital distribution generally will not be taxable but currently will reduce the shareholder's cost basis and will result in a higher capital gain or lower capital loss when those Fund Shares on which the distribution was received are sold. Once a Fund shareholder’s cost basis is reduced to zero, further distributions will be treated as capital gain if the Fund shareholder holds Fund Shares as capital assets. Additionally, any capital returned through distributions will be distributed after payment of Fund fees and expenses. Because a significant portion of the Fund’s distributions will consist of return of capital, the Fund may not be an appropriate investment for investors who do not want their principal investment in the Fund to decrease over time or who do not wish to receive return of capital in a given period.
Market Risk. Market risk is the risk that a particular security, or shares of the Fund ("Fund Shares") in general, may fall in value. Securities are subject to market fluctuations caused by such factors as economic, political, regulatory or market developments, changes in interest rates and perceived trends in securities prices.
Managed Payout Risk. The Fund intends to pay monthly distributions to shareholders based upon based on the NAV of the Fund on the final business day of December each calendar year. Distributions will be paid from Fund assets regardless of the Fund’s performance or the level of dividends, income and capital gains earned by the Fund, and will reduce the amount of assets available for investment by the Fund. If distributions paid by the Fund exceed the Fund’s earnings and profits, distributions of that excess will be treated as a return of capital to the extent of your tax basis in your Fund Shares.
The targeted annual distribution rate to be paid by the Fund each year is based on the NAV of the Fund on the final business day of December of the prior year. The targeted annual distribution rate is not guaranteed and may be decreased or increased in the future. The actual annual distribution rate paid by the Fund each month or year may be higher or lower than the targeted rate.
SPY ETF Risks. The Fund will have significant exposure to the S&P 500 Index and the SPY ETF through its investments in the SPY FLEX Options. Accordingly, the Fund will subject to the risks of the SPY ETF.
FLEX Options Risk. Trading FLEX Options involves risks different from, or possibly greater than, the risks associated with investing directly in securities. The Fund may experience losses from specific FLEX Option positions and certain FLEX Option positions may expire worthless. The FLEX Options are listed on an exchange; however, no one can guarantee that a liquid secondary trading market will exist for the FLEX Options. In the event that trading in the FLEX Options is limited or absent, the value of the Fund’s FLEX Options may decrease.
Active Management Risk. The Fund is actively-managed and its performance reflects investment decisions that the Adviser and/or Sub-Adviser makes for the Fund. Such judgments about the Fund’s investments may prove to be incorrect.
Active Market Risk. Although Fund Shares are listed for trading on the Exchange, there can be no assurance that an active trading market for Fund Shares will develop or be maintained.
Concentration Risk. The Fund may be susceptible to an increased risk of loss, including losses due to adverse events that affect the Fund’s investments more than the market as a whole, to the extent that the Fund’s investments are concentrated in the securities and/or other assets of a particular issuer or issuers, country, group of countries, region, market, industry, group of industries, sector, market segment or asset class.
Derivatives Risk. The use of derivative instruments (i.e. options contracts) involves risks different from, or possibly greater than, the risks associated with investing directly in securities and other traditional investments. These risks include: (i) the risk that the counterparty to a derivative transaction may not fulfill its contractual obligations; (ii) risk of mispricing or improper valuation; and (iii) the risk that changes in the value of the derivative may not correlate perfectly with the underlying asset.
New Fund Risk. The Fund is a recently organized investment company with a limited operating history. As a result, prospective investors have a limited track record or history on which to base their investment decision.
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
S&P 500 Index (S&P 500®): The S&P 500 Index is a measure of large-cap U.S. stock market performance. It is a float-adjusted, market capitalization-weighted index of 500 U.S. operating companies and real estate investment trusts selected through a process that factors in criteria such as liquidity, price, market capitalization, financial viability and public float. It is rebalanced quarterly in March, June, September and December.
Distribution Rate: The annual rate an investor would receive if the most recent fund distribution remained the same going forward. The rate represents a single distribution from the fund and does not represent total return of the fund. The distribution rate is calculated by annualizing the most recent distribution and dividing by the most recent fund NAV.
Price Return: Price Return reflects the percentage change in the price of an ETF over a given period. The Fund’s secondary investment objective is to provide exposure to the return of an index composed of U.S.-listed large cap equity securities.
Total Return: Total Return reflects the percentage change in the price of an ETF over a given period with distributions are reinvested. The Fund seeks to provide exposure to the return of the S&P 500 Index while making monthly distribution payments equal to an annualized rate of twenty percent (20%). A return of capital distribution should not be considered part of the Fund’s dividend yield or total return of an investment in Fund Shares.
