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Advisors that are fans of exchange traded funds -- data confirm there are plenty of you out there –probably know something about defined outcome ETFs.
Also known as buffer ETFs, these options-based products debuted in 2018. Today, the group is home to 208 products with a combined $44.26 billion in assets under management. No small feat when considering the average expense ratio on a buffer ETF is 0.78% -- extremely high relative to ETF industry standards.
The objective of these ETFs is easily conveyed to clients, though that’s not necessarily an endorsement. Defined outcome ETFs provide some upside capture while providing downside protection. Said differently, the end user of a defined outcome ETF is exchange some upside potential for a downside buffer. The initial iterations of these funds typically capped upside while providing, say, downside protection of 10% to 20%. So if the S&P 500 declined 10% over a given period, a properly functioning defined outcome ETF based on that index would subject an investor to just 10% to 20% of that drop.
Sounds good and it is practical for some clients, but there’s more. Ever intrepid ETF issuers, including some of the industry’s largest, have recently introduced defined outcome ETFs that purport to have 100% downside protection. Yes, there’s probably a catch.
Looking at the Cons
Lewis Braham of Barron’s said it best: “No downside risk—it’s the dream of every stock investor.” However, smart advisors know that in investing there’s no such thing as a free lunch – advice to be remembered with regards to buffer ETFs.
The obvious catch is that an instrument with total downside protection is going to sacrifice significant upside in strong-trending bull markets. One can debate the strength of the current bull market in stocks, but it very likely is a bull market, indicating now probably isn’t the appropriate for the vast majority of clients to embrace 100% downside protection. That assertion could be cemented when the Federal Reserve finally lowers interest rates.
“The upside cap typically equals the T-bill rate for the duration of the options, plus a spread. The current cap for 100% protection ETFs with an outcome period between July 2024 and July 2025 is around 10%, or nearly double the one-year risk-free rate,” observes Morningstar’s Lan Anh Tran. “As interest rates come down, however, the cap will also decrease and might lose its appeal. While the potential returns might be higher than a certificate of deposit or plain Treasury bills, investors can miss out on substantial stock market gains. In addition, principal protection is not guaranteed the same way a CD would be, nor is the stated cap always achieved.”
Another issue is timing. Market timing is incredibly difficult and a fool’s errand, but buffer ETFs work best when held over the entirety of the defined period. So if it’s a one year buffer ETF, it’s best to buy it on the first trading day of the year and sell it on the last.
“Consider an ETF that starts its outcome period on Jan. 1, 2024. If investors buy in on July 15 and the S&P 500 has already climbed close to the ETF’s upside cap, they risk severely limiting their upside while exposing themselves to downside if the index declines,” adds Tran.
Alternatives to 100% Buffer ETFs
As noted above, there are clear drawbacks to 100% downside protection, implying the funds are relevant to only a sliver of an overall client base. Fortunately, there are alternatives.
Annuities – to which defined outcome ETFs are often compared – are likely to be relevant to clients and if it’s true downside protection a client needs, still elevated yields on cash instruments could be appealing. And there’s always the staples of stocks and bonds.
“On a rolling one-year basis, the S&P 500 most frequently returned between 10% and 20%, which is beyond the current annualized upside caps of these ETFs,” concludes Tran. “The opportunity cost of capping returns is substantial, especially after compounding that disadvantage over longer periods of time. Missing 5%-10% a year compounds into missing between 27% and 61% cumulatively over just a five-year holding period.”
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