Derivative Income Can Be Costly

Investors seeking high yields in their stock allocations have been flocking to the category known as derivative income funds. This breed of products combines equity index exposure with options to generate income, producing higher-than-bond yields. Inthe first half of 2025 alone, 36 new derivative income funds were launched, and more than $30 billion in net flows were directed to the category.

Higher yields don’t always equate to higher returns. Over the past 10 years, the net return to the derivative income fund category was 7.12%, compared to 12.05% for large blend funds.

But some investors prefer their total return to be disproportionately composed of income. These investors should be aware that the income generated by options in derivative income funds is often treated as ordinary income for tax purposes, and that may drive up an investor’s tax bill.

This is apparent in the stark effect on returns that are preserved after taxes. Over the 10-year period ending June 30, 2025, only about 65% of returns survived taxes for the derivative income fund category, compared to 85% for large blend funds.