For bond investors, taxes are a constant annoyance. A new breed of ETFs aims to solve that problem, but there are risks.

With both stocks and bond markets looking iffy, plenty of investors are trying to shore up their cash positions. Top money-market funds pay interest just under 4%, making them a good option. Uncle Sam, however, typically takes a big bite of the returns, because bond interest is taxed as income.

The Alpha Architect 1-3 Month Box exchange-traded fund, frequently referred to by its ticker BOXX, has tried to mitigate the tax issue. The fund employs a so-called box spread strategy that involves placing pairs of offsetting bets on option contracts to generate total returns slightly exceeding short-term Treasuries.

The even bigger advantage, however, is that profits from trading index options are taxed like capital gains. Investors that hold the BOXX for at least one year qualify for long-term capital gains rates, which top out at 20%, rather than income-tax rates that range up to 37%.

Over the past 12 months, the Alpha Architect 1-3 Month Box ETF has returned 4.05%, compared with 3.81% for the iShares 0-3 Month Treasury Bond ETF, the market's most popular cash-like ETF. The State Street SPDR Bloomberg 1-3 Month T-Bill ETF, whose duration precisely matches BOXX's, has returned 3.73% over that span.

BOXX has been a big hit, garnering $14 billion from investors since hitting the market in 2022 and spawning a number of competitors. These include the XFunds 1-3 Month Box ETF and the Roundhill Ultra Short Duration No Dividend Target ETF.

Box spread funds have some downsides. They follow a well-established institutional options trading strategy that shouldn't deliver major surprises-but it isn't as safe as owning Treasury bonds.

For instance, option contracts are backstopped by the Options Clearing Corp., rather than the Treasury Department.

"It is technically a lower credit than the U.S. government, you could argue there is some credit risk there," notes Alpha Architect founder and CEO Wes Grey. "If you want a little extra return, you have to take a different credit risk."

Perhaps a bigger consideration are the caveats around these funds' tax advantages. The box spread strategy aims to deliver investor returns in the form of long-term capital gains rather than income, but it isn't that simple. First, investors need to hold the funds for at least one year to qualify for the advantageous tax treatment. That means the ETFs might not be suitable for anyone looking for ready access to their money-which is often the case with cash.

State taxes are also a potential issue. Income from Treasuries is exempt from state and local taxes. That means while Treasury holders pay federal income-tax rates on interest from Treasury bonds, they don't owe state and local income tax. Investors who own Boxx funds lose that benefit.

That's no big deal for investors who live in income-tax free states like Texas or Florida. But in states like New York and California that do levy taxes on income-and capital gains-investors' increased state tax bills can offset a significant portion of their potential federal income tax savings.

It's also worth noting investors who buy these box spread ETFs face at least some risk the Internal Revenue Service could shut down the strategy. A number of tax experts questioned the strategy after BOXX first appeared in 2022.

There is some good news for BOXX investors, though. New York University Law School professor Daniel Hemel, one of the fund's vocal critics, told Barron's that recent tweaks to the fund's investment strategy make it more likely to survive any IRS attack than when he spoke out about it a couple of years ago.

Still, the funds aren't completely in the clear. Box spread ETFs were among several debated ETF strategies highlighted in a discussion between IRS officials and Wall Street tax experts at an event sponsored by the Wall Street Tax Association in July.

Alpha Architect's Grey declined to comment on how the IRS might ultimately decide to view the box spread strategy. He did say the funds' Treasury-beating total return should give investors a reason to own the fund that has nothing to do with the tax benefits.