Should Defined Outcome ETFs Replace Bonds?

Critics of defined outcome ETFs often highlight the higher fees and lack of dividend income when compared to the underlying benchmarks they track. But depending on how these increasingly popular ETF strategies are used inside investor portfolios, such comparisons might be misleading.

An average expense ratio of 78 basis points for defined outcome ETFs looks pricy compared to the Vanguard S&P 500 ETF (VOO) at 3 basis points.

And when you add in the roughly 150 basis points worth of dividend income from an S&P 500 ETF the defined outcome ETF buffer of downside protection in exchange for an upside cap on performance looks even more expensive.

But what if these defined outcome strategies that are gaining appeal among risk-averse investors are instead used as substitutes for fixed income?

While such a strategy doesn’t remove the fee disparity or dividend income factor, it does introduce an opportunity for bond-like downside protection with some equity-like upside potential.

“It always comes back to comparing these products to the S&P 500, but if you wanted the S&P, you would never even look at these products,” said Johan Grahn, head ETF market strategist at Allianz Investment Management in Minneapolis.

Defined Outcome ETFs' Potential

As Grahn sees it, the real potential of defined outcome ETFs, which have been referred to as “Boomer Candy” because of the growing appeal among older investors, is pumping up the bond side of a portfolio.

The downside buffer of these ETFs, which typically protects against the first 15% to 20% of losses, will enable investors to weather a lot of market volatility.

There’s even a trend toward offering 100% downside protection, including the iShares Large Cap Max Buffer Jun ETF (MAXJ).

And in upside potential, these strategies come in many flavors. MAXJ, for example, caps upside at 10.6% if the ETF is held to its 12-month maturity.

Allianz, which has a couple different suites of defined outcome ETFs, rolled out a series in April with the AllianzIM U.S. Equity Buffer15 Uncapped April ETF (ARLU) that limits losses to 15% and takes the first 3% of gains over the 12-month cycle. That means if the underlying index finishes up 4% the ETF investor gets a 1% gain and anything beyond that.

The key, according to Grahn, is thinking beyond traditional bonds for the fixed-income slice of a diversified portfolio.

“If the portfolio is 60% pure equity and 40% buffered equity there isn’t a real benchmark for the fixed income side, but the theoretical benchmark would be the Barclays Agg,” he said. “The buffered equity gives you a big cushion just like bonds, but the difference is upside potential that’s significantly greater than the Barclays Agg.”