Investment Primer: Synthetic Income Composite

What, Why, and How of Synthetic Income

Synthetic income strategies are designed to generate cash flow for a fund using derivatives, such as options, rather than relying on traditional sources like stock dividends or bond interest payments. The “synthetic” part of the name refers to the fact that the income is manufactured through these derivative contracts. The primary driver for these strategies is the pursuit of high current income, which can often be significantly higher than what is available from conventional investments.

At their core, most synthetic income strategies work by selling options and collecting the premium. The two most common approaches are covered calls and put-writes. In a covered call strategy, the fund owns an underlying asset (like a stock or an index) and sells call options against it, collecting a premium in exchange for capping the potential upside. In a put-write strategy, the fund sells put options, collecting a premium while taking on the obligation to buy the underlying asset at a set price if it falls. In both cases, the fund is making a trade-off: sacrificing some potential for capital gains or taking on downside risk in exchange for an immediate, consistent income stream from the option premiums.

Understanding the Synthetic Income Mandate: Introduction to Derivative Income Strategies

The strategies outlined in the document can be broadly categorized into two main types based on their underlying instruments: those focused on individual equities (stocks and ETFs) and those focused on broad-based market indexes. This distinction is critical as it is the primary driver of their differing tax treatments. Equity-based strategies, which involve writing options on specific company stocks or ETFs , consistently result in income being treated as short-term capital gains. In contrast, strategies employing options on specific broad-based indexes like the S&P 500 (SPX) benefit from the special Section 1256 60/40 tax rule, where 60% of the gain is treated as long-term and 40% as short-term, regardless of the holding period.

The Role of Return of Capital (ROC)

A common and often misunderstood feature of synthetic income fund distributions is Return of Capital (ROC). ROC occurs when a fund distributes more cash than it has generated in realized income and gains for the period. In essence, the fund is returning a portion of the investor’s original principal. ROC is not inherently “good” or “bad”—its quality depends entirely on how it was generated.

Constructive vs. Destructive ROC: “Constructive” ROC is an intended, tax-efficient outcome of a strategy. For example, in a put-write strategy, if a put is exercised, the premium received is used to reduce the cost basis of the newly acquired stock. This is a non-taxable event that defers taxes, and any distribution from it is considered ROC. This is a “good” form of ROC because it is earned via the option premium. “Destructive” ROC occurs when a fund’s strategy fails to generate enough income to cover its distribution, forcing it to dip into its principal to make the payment. This is common in covered call funds during a down market, where large unrealized losses on the underlying stocks far outweigh the small option premiums collected. This type of ROC erodes the fund’s Net Asset Value (NAV) and the investor’s capital base.
Factors Influencing ROC: A manager’s control over ROC is limited. Key factors within a manager’s control include the fund’s distribution policy (a high, fixed payout is more likely to lead to destructive ROC) and the specifics of the option strategy (strike selection, timing). However, the primary drivers are often outside the manager’s control, namely market conditions. In a sharp downturn, it is almost impossible for many of these strategies to generate enough realized income to avoid paying out destructive ROC.

Strategy Breakdowns and Limitations

Covered Calls (on Index and Equity)

Strategy Recap: These strategies involve owning an underlying asset and selling call options against it , either on an index or an individual equity. The tax treatment is 60/40 for index calls and short-term capital gain for equity calls.
Limitations and Income Character:
- Capped Upside Potential: The primary limitation is that the strategy caps the potential profit from the underlying asset. If the stock or index price soars far above the option’s strike price, the fund is obligated to sell, missing out on all subsequent upside. This forced sale results in a realized gain, which is taxed according to the strategy type.
- Significant Downside Risk: Selling a call option offers minimal protection if the underlying asset’s price falls. The premium received is small compensation for a potentially large loss in the asset’s value. In a down market, the fund is left with large unrealized losses on its holdings while only collecting small option premiums. If the fund pays a distribution in such a period, it is highly likely to be classified as Return of Capital (ROC) because there is little to no net realized income to attribute it to.

Put-Writes (on Index and Equity)

Strategy Recap: These strategies involve selling cash-secured put options. The seller collects a premium and agrees to buy the underlying asset at a set price. The income is taxed under the 60/40 rule for indexes and as a short-term capital gain for equities.
Limitations and Income Character:
- Obligation to Buy a Falling Asset: The core risk is being forced to buy an asset after its price has declined. This happens when the put option is exercised.
- No Immediate Income on Exercise: If the put is exercised, the fund spends cash to acquire the stock. This transaction itself does not generate taxable income. The fund has simply exchanged cash for stock. Therefore, if a fund’s put options are consistently being exercised during a downturn, it will be generating very little realized income, making it highly probable that any distributions it pays will be characterized as ROC. The only realized income is the premium from puts that expire worthless.

0DTE (on Index and Equity)

Strategy Recap: This is a high-frequency strategy of writing and closing option positions that expire on the same day. Tax treatment follows the underlying instrument: 60/40 for index options and short-term capital gains for equity options.
Limitations and Income Character:
- Exposure to Extreme Volatility (Gamma Risk): While premiums are small, a sudden, sharp market move can cause catastrophic losses that far exceed the income generated from many successful trades.
- Constant Realization: The high-frequency nature means gains and losses are realized daily. This constant realization results in a steady stream of taxable income (either short-term or 60/40). This can lead to less ROC compared to longer-term strategies, as income is constantly being booked. However, a single day of massive losses can wipe out prior gains, and if a distribution is paid during a losing period, it will be classified as ROC.

Complex & Combined Options

Strategy Recap: This strategy employs multiple option positions at once, such as “collars”. The tax treatment is varied and depends on the mix of instruments used, potentially combining Section 1256 and short-term gains.
Limitations and Income Character:
- Conflicting Profit/Loss Profiles: The primary limitation is that the legs of the strategy can work against each other. For example, in a collar, the protective put designed to limit losses also eats into the income generated by the call option.
- Lumpy and Unpredictable Realized Income: Because the strategy combines different instruments, the net result can be very unpredictable. A gain on one leg might be offset by a loss on another. This lumpiness makes it difficult to maintain a steady level of realized income, making ROC a useful tool for the fund to smooth out its distributions to shareholders.

Structured Product Strategies

Strategy Recap: This strategy involves buying financial instruments like Equity-Linked Notes (ELNs) where the derivative component is created by an issuer.
Limitations and Income Character:
- Issuer Credit Risk and Lack of Control: The fund is dependent on the financial health of the institution that issued the note. Furthermore, the fund has no direct control over the embedded derivatives.
- Unfavorable Tax Treatment: The most significant limitation is the tax character of the income. The document states that income from these notes is almost always treated as ordinary income. This is the highest tax rate for most investors and offers none of the benefits of long-term capital gains or the Section 1256 rule. There is no opportunity for this income to be re-characterized; it is passed through directly as ordinary income.

A Practical Guide to Locating Funds in the ETF Action Database

A proper peer group is essential for any comparative analysis. A good starting point is the Non-Traditional Composite ETF Dashboard, which groups all alternative ETFs first by composite and then by category, with hyperlinks to the ETF Database for deeper analysis. The ETF Action classification system allows users to screen for and refine a list of Synthetic Income funds.

Foundational Screening: Building the Initial Universe

The first step is to use the top-level classification filters to isolate all funds within the Synthetic Income composite.

Step 1: Select the Database. Navigate to the ETF, Mutual Fund, or other desired database.
Step 2: Filter by Asset Class. Select Asset Class = Non-Traditional to narrow the universe to specialized strategies.
Step 3: Filter by Composite. Select Composite = Synthetic Income to isolate funds with this specific mandate.
Step 4: Filter by Category. Select Category = Equity, Fixed Income, Crypto, etc.
Step 5: Filter by Implementation. To focus on a specific approach, use the Implementation filter to select Covered Call, Put-Write, Option Collar, or other defined strategies.

Advanced Filtering: Screening for Outliers and Refining Peer Groups

After the foundational screen, the list can be refined by screening for outliers based on key data points. This helps create a more relevant group for comparison by removing funds that may be too small, expensive, or illiquid.

Brand (Issuer): Investors may prefer to stick with established fund providers. Screening by brand allows an analyst to focus on issuers with a long tenure and a demonstrated commitment to the alternative space.
Assets Under Management (AUM): AUM can indicate a fund’s stability and investor acceptance. Setting a minimum AUM threshold (e.g., >$100 million) can screen out smaller funds that may face viability risks. Persistent outflows can also be a red flag.
Expense Ratio: Synthetic income strategies tend to have higher fees, but costs can vary. Screening by expense ratio can eliminate high-cost outliers, as fees are a direct hurdle to achieving the income objective.
Liquidity (ETFs only): For ETFs, liquidity is critical. Metrics like average daily trading volume and bid-ask spreads can be used to screen out illiquid funds, which can be difficult and costly to trade.

Understanding the Underlying Exposure

A synthetic income strategy is an overlay applied to an underlying market segment. Before evaluating the income component, it is critical to identify what the fund is targeting, as this is the primary driver of its risk and total return profile. These strategies can be applied to a wide range of segments, including U.S. Large Cap (S&P 500), U.S. Small Cap (Russell 2000), international stocks, specific fixed income markets (long-term Treasury bonds), commodities, cryptocurrency, or even single stocks. This information can be identified in the ETF Action database using the Market, Region, and Segment classification fields.

The volatility of the underlying segment directly impacts the strategy’s income potential. Higher volatility generally leads to higher option premiums, which can translate into a higher distribution yield. For example, a covered call strategy on a volatile single stock will typically generate more income than one on a broad, diversified index. However, this higher income comes with greater risk, as the underlying asset is more susceptible to large price declines.

For a meaningful evaluation, it is essential to compare the fund not just to its peers, but also to a benchmark that represents its underlying exposure. The Beta Tracker assigned to each fund in the ETF Action database serves this purpose. By comparing the synthetic income fund’s total return to its Beta Tracker, an analyst can measure the trade-offs made—specifically, how much potential upside was sacrificed in exchange for the income generated.

A Framework for Evaluating Synthetic Income Funds

Evaluating Synthetic Income funds requires looking beyond the advertised yield. The primary goal is to understand the trade-offs between income generation, risk, and total return.

Quantitative Analysis: A Non-Traditional Toolkit

The quantitative evaluation must focus on the source and sustainability of the income, as well as the impact on the fund’s overall value. All of the data points discussed in this section can be sourced directly from ETF Action’s databases and reporting tools.

Measuring Performance and Income

Total Return vs. Distribution Yield: This is the most critical comparison.
- Distribution Yield is the income paid out to investors, which is often the main attraction. However, these distributions can include a “return of capital,” which means the fund is simply returning a portion of the investor’s original investment.
- Total Return accounts for both the distributions and the change in the fund’s net asset value (NAV). A high yield with a declining NAV means the total return may be low or even negative.
NAV Erosion: Closely related to the above, it’s important to track the fund’s NAV over time. If distributions consistently exceed the income and gains generated by the strategy, the NAV will erode, and the dollar amount of future distributions will fall even if the yield percentage remains high.

Deconstructing Risk and Diversification

Volatility (Standard Deviation): Measures the dispersion of returns. While income may be consistent, the fund’s underlying value can still be volatile.
Maximum Drawdown: Captures the largest peak-to-trough decline a fund has experienced. This shows how much capital was at risk during market downturns.
Upside/Downside Capture Ratios: These are especially important for covered call strategies. They show how much of the market’s gains the fund captures versus how much of the losses. A low upside capture ratio is a direct consequence of selling call options and highlights the trade-off made for income.

Qualitative Analysis: Looking Beyond the Numbers

While the numbers show what a fund has done, they don’t explain how or why. For synthetic income funds, understanding the mechanics of the strategy is essential.

This requires getting comfortable with the playbook behind the fund. What is the specific implementation? If it’s a covered call fund, what is it writing calls on (a broad index or volatile single stocks)? How far out-of-the-money are the options? This determines the balance between income generation and potential for capital appreciation.

If the fund uses ELNs or ETNs, it’s critical to assess the counterparty risk of the issuing institution. For a fund-of-funds, an investor must look at the underlying holdings and be aware of the layered fees.

Finally, check the parent company. Does the firm have a solid, long-term commitment to these more complex strategies, or a history of launching and closing funds when they’re no longer trendy? A disciplined, repeatable process for managing risk is non-negotiable, especially when strategies involve derivatives or leverage.

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