Defined Outcome ETFs Catch a Wave

This is the second in a series of columns by CFRA's Head of ETF Data and Analytics Aniket Ullal, in which he'll be sharing exclusive insights on ETF industry expectations for 2023.    

Mutual Fund to ETF Conversions May Accelerate, CFRA Says 

ETF Industry Draws Political Battle Lines

A key factor in the success of exchange-traded funds is that issuers continually innovate and offer investors an ever-expanding tool kit of products. As in any emerging space, many of these new products failed to succeed, particularly since a few established firms dominate the market.  

However, history shows that when a new ETF product category is in sync with the investing environment, it’s possible for the issuer to “catch a wave” and ride it to asset-gathering success. 

Defined outcome ETFs uniquely suited the investment zeitgeist of 2022. In a rare year when stocks, bonds and gold were all down simultaneously, investors were looking for safe havens.  

These ETFs were able to offer investors a downside buffer, while still allowing them to participate in some upside. The adoption of these products also reflects the development of the ETF industry from its low-cost beta roots toward more structured solutions for investors. 

Breakout Year for Defined Outcome 

CFRA estimates that defined outcome ETFs took in over $10 billion in net new flows this year as of Dec. 9. To put that in perspective, low volatility ETFs, another successful category this year, also took in $10 billion in net flows, but its asset base is more than three times that of defined outcome ETFs. Defined outcome was one of the most successful product categories in the U.S. this year in terms of flows-to-assets ratio.  

CFRA estimates the size of the defined outcome ETF category in the U.S. to be $20 billion as of Dec. 9, 2022. The first defined outcome ETF in the U.S. was launched by Innovator Management in 2018. Other firms, including First Trust and Allianz, now offer similar products.  

Table 1 summarizes the issuers who have launched products in this category. Note that the table includes only those products that CFRA classifies as defined outcome (i.e., simultaneously limit upside and offer some downside protection), and doesn’t include every ETF that offers some form of downside protection.  

Table 1: Issuers of Defined Outcome ETFs in the U.S.

Source: CFRA Research; Data as of December 9, 2022.

Understanding Is Critical for Investors  

The way most defined outcome ETFs are structured is that they are issued in a specific month and for a defined outcome period, typically one year. The ETF has a predefined starting downside buffer (e.g., first 9% of losses) and upside cap (e.g., 25%). So theoretically, this buffer and cap would apply to an investor who invests on the first day of the outcome period and holds the ETF through the outcome period.  

In practice, however, investors may not always buy the ETF on the first day of an outcome period. The original buffer and caps are designed in reference to the first day of the outcome period, not the date on which the investor buys the product.  

As a result, investors need to understand the remaining buffer and cap from the day they invest for any specific ETF. For example, if an investor buys an ETF where the reference index has declined from the start of the outcome period, the remaining upside cap may now be more than the original cap, and the remaining downside buffer percentage may be less than the original buffer.  

One potential drawback of this product category is that it requires investors to research and understand these specific features. Investors need to look carefully into the remaining caps and buffers before investing in an ETF, instead of going purely by the original limits specified “on the tin.”  

It’s also important to understand these products don’t entirely eliminate downside risk. However, they offer interesting possibilities for investors who are willing to understand the product design. It allows them to put some boundary ranges on returns by selecting ETFs based on outcome dates and remaining buffers and caps. This type of structuring is not possible with traditional indexed ETFs.  

Growth in Product Availability  

The number of defined outcome ETF launches has grown, from 55 in 2020—or 20% of all U.S. ETF launches—to 63 last year. Fifteen launched this year through Dec. 9, as the category matured.  

This rapid product proliferation is partly explained by issuers needing one ETF for each calendar month of the year to complete a family of products. The products available in the U.S. encompass a range of reference indices, including U.S. large and small cap equities, developed and emerging ex-U.S. equities and fixed income. Figure 1 charts the growth in the number of defined outcome ETFs listed in the U.S.   

Source: CFRA Research; Data as of December 9, 2022.

The 2023 Outlook 

In 2023, it seems likely that the range of defined outcome ETFs will increase. One potential area of expansion is in nonequity asset classes like fixed income. Another area that is likely to grow in 2023 is “ETFs of defined outcome ETFs,” i.e., fund of funds that holds individual defined outcome ETFs in a laddered structure.  

The overall asset growth of defined outcome ETFs in 2023 will depend on the macro investing environment. An economic slowdown accompanied by equity market volatility could sustain demand for these products. Irrespective of the outcome, it will be an important trend for the ETF industry to track.  

This product category will be a bellwether for investor interest in solution-oriented ETFs that provide structured outcomes. The continued success of defined outcome funds could indicate how ETFs will evolve over the next few years.