How Defined Outcome ETFs Work

October 01, 2020

[This article appears in our October 2020 issue of ETF Report.]


Defined outcome ETFs aren’t exactly new at this point, with the first funds of this type launched by Innovator in August 2018. In fact, the concept behind them is rooted in annuities and structured products.

But given the market turmoil we’ve seen in 2020, they’re getting far more attention in this environment, especially now with stocks at all-time highs. The idea of protecting investment dollars from experiencing the full effects of a market downturn makes more sense with every new market high.

The demand we’ve seen from investors for these funds has been healthy, with the group of more than 70 ETFs pulling in over $2.5 billion in assets under management (AUM) this year.

They can be used in portfolios for a number of purposes related to taking some risk off the table. Ultimately, these strategies allow investors to stay in the market when volatility is up because of a built-in “buffer” from market losses.

That’s important, because many significant market gains can be attributed to single-day movements, and if you’re out of the market for even just a few days, you could find yourself missing out. Market timing is a loser’s game, as we know.

Defined outcome ETFs also have implications for retirement investing at a time when fixed income isn’t performing as it has done historically. Traditionally, investors reduce their equity exposure as they get closer to retirement and shift more of their portfolio into fixed income, seeking stability and income.

But with rates so low, fixed income isn’t what it used to be. With the added protection of the downside buffer, investors can conceivably maintain their equity allocations for longer than they normally would.

Keep in mind, though, these funds don’t pay equity dividends, and you’re taking on the risk that can come with derivatives, even if you’re limiting your equity risk.

Investors can even rotate the funds through their portfolios, locking in their gains and refreshing their buffers. For example, an investor could buy an Innovator Buffer ETF with downside protection of 9%. If the market rises over time and gets close to or exceeds its cap, the investor can sell the fund for a gain, then buy a similar ETF that resets on another date but has a higher cap remaining.

While Innovator was first to market with the concept, it was quickly followed by First Trust, then AllianzIM and TrueMark. There are currently about 70 defined outcome products on the market; likely there are more on the way.

How They Work
There are subtle differences between all the models. However, there are certain similarities that all of the funds seem to have in common.

For one thing, they all invest in Flexible Exchange (FLEX) options based on an index or ETF. The vast majority invest in FLEX options tied to the S&P 500 Index or ETFs that track it, though Innovator does offer some that track other key indexes like the MSCI EAFE Index or the Russell 2000 Index. There are also versions of these funds that offer exposure to fixed income (Figure 1).


For a larger view, please click on the image above.


In the simplest terms, the fund managers (all of the ETFs of this type are actively managed) buy call options to capture the upside and put options to provide the downside protection, though the reality is more complicated. Innovator’s documentation on how its funds work details seven different types of options positions used to achieve the strategy’s goals. The cost of the options on the reset day is what determines the upside caps or limitations.

The thing to remember is that the hard limits change after the first day. So, say the targeted market goes down 1% the next day. If you’re invested in a fund with 10% downside protection, you won’t experience that loss, but you only have another 9% left on that buffer.

If you enter the fund on that day, you start out with a 9%, not a 10%, buffer. Similarly, if you buy a fund that has a cap of 8.5% on its reset day, but you buy it only after it’s risen 1% from the reset day, you’ll only have 7.5% of potential upside remaining.

All of the issuers of these funds have tools available on their websites to let you know what limits you’ll be getting on the day you purchase one of their funds.

Other key points of differentiation are expense ratios and buffer/cap ranges. Here we’ll offer an overview of the issuers currently offering these products.

The founders of PowerShares—Bruce Bond and John Southard—acquired Innovator a few years after they sold that first ETF business to Invesco.

Bond was already considered a dynamo in the ETF space after turning PowerShares into a leading issuer. He and Southard returned for an encore with the purchase of Innovator. They had a solid idea of what they wanted to do, inspired by annuities to bring a new type of product to market—the defined outcome ETF.

In all, 36 of the ETFs in Innovator’s defined outcome lineup offer buffered exposure to the S&P 500 Price Index, with the “Buffer” ETFs protecting against the first 9% of losses, while the “Power Buffer” ETFs protect against the first 15% of losses.

The “Ultra Buffer” ETFs allow a 5% loss, but protect against the next 30% of losses, up to 35%. All of those funds come with an expense ratio of 0.79%, and reset annually. Innovator offers three of these ETFs for each month of the year.

The issuer also has similar products tied to the Nasdaq-100, Russell 2000, MSCI EAFE and MSCI Emerging Markets indexes, and recently launched fixed income versions that invest in FLEX options on the iShares 20+ Year Treasury Bond ETF (TLT).

The Innovator 20+ Year Treasury Bond 9 Buffer ETF – July (TBJL) protects against a loss of up to 9%, while the Innovator 20+ Year Treasury Bond 5 Floor ETF – July (TFJL) has a 5% floor and doesn’t allow investors to lose anything after that.

Innovator currently has more than $3 billion in AUM invested in these funds.

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