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As of the end of October, there were 3,724 exchange traded products – ETFs and exchange traded notes (ETNs) – listed in the U.S. A staggering amount and one that implies it’s logical clients will have questions about some of the ETFs they’re apt to come into contact with.
One segment of the ETF landscape that’s ripe for client inquisition and that’s not necessarily a bad thing is defined outcome ETFs. Also known as “buffer” or downside protection ETFs, these products have swelled in popularity in recent year, confirming advisors, among other market participants, are putting capital to work in these products.
From the end of 2018 through the start of 2023, assets under management at defined outcome ETFs surged more than 20-fold – a staggering growth rate for funds that don’t capture all of a market segment’s upside (more on that later).
The terminology “defined outcome” is derived from the fact that these ETFs have a target-date element to them in that there’s an expiration or reset date. For example, the Innovator U.S. Equity Buffer ETF – December resets in December. That’s an important part of the defined outcome ETF equation, but there’s much more to the story.
Clients Should Be Inquisitive
Buffer ETFs epitomize the old saying about there never being a free lunch in investing. To gain the downside protection offered by these products, investors sacrifice something and it’s significant. That being full participation in a bull market.
If an advisor is recommending these funds to a client, that client should inquire about how that protection is achieved and why it’s potentially useful.
“What they’re doing is they’re using options to kind of trade around that. So usually they’ll sell call options to kind of cap the upside, but they’ll use that premium they get from selling the call option to buy a put option, which gains value when markets lose money,” notes Morningstar analyst Jason Kephart. “So that’s how you kind of get that neutral zone of your returns you can expect.”
As noted above, there’s also a time element with buffer ETFs and clients should be inquisitive about that as well because a one-year expiration, while common, isn’t the case across the entire landscape.
“It can be six months. It’s really important that investors read the fine print on these because that time frame is really important,” adds Kephart. “Because that’s the only time the defined outcome is really in effect. And you’re holding it longer, it may reset. If you’re buying it in between those periods, you may get a different outcome. I think it’s really important to know what you’re getting into before you buy these.”
Be Sure to Ask About Fees, Too
Among the many ways in which ETFs have benefited fund investors is the delivery of lower annual fees, meaning market participants keep more of their money.
However, not all ETFs are “cheap” and that’s particularly true in the world of options-based ETFs, defined outcome and otherwise. Universally, these funds carry higher expense ratios than pure beta equivalents, indicating that clients should ask advisors about the fees they’ll be subjected to on buffer funds. After all, it’s the client’s right to know this information.
“There’s always a catch, right? And these ETFs are more expensive than you probably think, especially if you’re capping your upside at 5% or 10% to the stock market,” concludes Kephart. “The average expense ratio is about 80 basis points. The cheapest ones are around 50. The most expensive ones go up to about 100 basis points.”
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