AIYY Is an Income ETF Monster

Key Points

• AIYY pays a distribution yield of more than 100%.

• But it’s mainly returning its investors’ cash through those distributions.

• It’s tethered to C3.ai, which has been highly volatile over the past year.

Over the past three years, Tidal Financial Group released several high-yield exchange-traded funds (ETFs) with jaw-dropping yields. One of the highest-yielding ones was the YieldMax AI Option Income Strategy ETF (NYSEMKT: AIYY), which was launched in November 2023 and currently pays a distribution rate of 100.8%. Many might scoff at any income investment that pays a monstrous 100% yield, but is it really a high-yield trap?

How does this ETF pay a distribution rate of more than 100%?

To understand how an ETF like the YieldMax fund works, we should discuss covered call options. In a covered call, you sell a call on a stock you own by choosing an option with a strike price that's higher than the current share price and an expiration date in the future. The buyer pays you a premium for the call, and the value of that option varies according to the stock's volatility and its proximity to the expiration date.

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If that stock is still trading below the covered call's strike price at its expiration date, you'll keep your shares and the premium, and the buyer will leave empty-handed. But if the stock has climbed above the strike price, you'll keep the premium but end up selling your shares at that strike price.

Many investors write covered calls on their own stocks to generate passive income. That strategy works well when the market trades sideways, but it can backfire during big rallies. To offer investors an alternative to handling the covered call strategy manually, Tidal launched covered-call ETFs, which are pinned to volatile stocks that pay out high premiums that support its distributions.

Why is the YieldMax ETF messier and riskier than simple covered calls?

The YieldMax fund mainly sells short-term calls (with strike prices 5% to 15% higher than the current stock price) each month to boost its distributions, while parking some of its excess cash in short-term Treasuries to earn interest. This particular ETF's underlying stock is C3.ai (NYSE: AI), the divisive enterprise artificial-intelligence AI software maker that still trades more than 40% below its initial public offering (IPO) price. But unlike a regular investor, who writes covered calls to generate passive income, the ETF doesn't actually own any shares of C3.ai.

Instead, the fund writes covered calls on a "synthetic" long position comprised of longer-dated call and put options instead of owning the stock. That approach requires less capital, since it doesn't need to buy 100 shares of C3.ai for each covered call.

If C3.ai shares decline, the ETF's synthetic position is designed to match those declines. However, that requires perfect hedging, which can be challenging. Long-dated options used in synthetic positions also decay over time, and the fund needs to keep rolling those positions forward to keep up with C3.ai's shares.

The ETF will underperform C3.ai over the long run

C3.ai trades far below its IPO price, but its revenue growth accelerated again in fiscal 2024 and fiscal 2025 (which ended this April). And it recently extended its crucial deal with Baker Hughes, which accounts for over 30% of its revenue, for another three years. Those catalysts -- along with its fresh federal contracts, cloud partnerships, and generative AI tools -- could drive the stock higher over the next few years.

But even if that happens, the YieldMax ETF will underperform C3.ai stock as its covered call strategy limits its gains. Ideally, it can narrow that gap with its big distributions -- but the messy way it uses synthetic long positions could cause it to lag behind C3.ai stock. To make matters worse, investors need to pay an annual expense ratio of 1.67% to execute the fund's convoluted strategy, which is much more expensive and confusing than simply buying C3.ai shares and manually writing covered calls.

That's a big part of why the ETF's shares declined 64% over the past 12 months as C3.ai's stock only fell 14%. Even if you had reinvested the fund's big distributions, you would have still ended up with a negative total return of 24%.

Investors are mainly getting back their own money

Lastly, most of the ETF's distributions are a return of capital (ROC), which means it's mainly returning its investors' cash instead of generating any fresh income. That strategy is constantly eroding its net asset value (NAV) -- which has already dropped 64% over the past 12 months -- and will further limit its upside potential.

That's why that 100.8% distribution yield doesn't mean you'll magically double your investment by buying its shares and waiting for the next distributions. That ratio simply means that if its most recent monthly distribution were paid out every month for a year, its total annualized payout would be equivalent to 100.8% of the ETF's current price. But that ratio looks backward instead of forward, and its monthly payouts could decline sharply if C3.ai's volatility declines or its stock crashes.

Investors should avoid this "income monster"

The YieldMax AI Option Income Strategy ETF might seem like an income-generating monster, but it's a dangerous investment. You're mainly getting back your own money, you're being charged for it, and the ETF will still underperform C3.ai's stock if it rallies -- yet experience steeper declines if it pulls back. Investors should avoid it and stick with more-reliable dividend stocks instead.

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Leo Sun has no position in any of the stocks mentioned. The Motley Fool recommends C3.ai. The Motley Fool has a disclosure policy.