New Buffered ETF Offers Complete Downside Protection From Equity Losses

[This article is part of a new series from etf.com highlighting innovation in ETFs.] 

Defined outcome ETFs have become popular with financial advisors and their risk-adverse clients in the past few years, as the funds set guardrails between investors’ equity market gains and losses. But a new exchange-traded fund is designed to offer buyers reward without risk. 

The Innovator Equity Defined Protection ETF (TJUL) seeks to track the return of the SPDR S&P 500 ETF Trust (SPY). It launched July 18, promising a 100% buffer to stock market losses over a two-year period, with investors’ upside initially capped at 16.6%. It’s already attracted nearly $115 million in assets under management in its short life, despite a higher than usual 0.79% expense ratio for an ETF. 

Innovator ETFs created defined outcome ETFs, also known as buffered ETFs, and this is the first among them to offer 100% protection from market losses. Tim Urbanowicz, the firm’s head of research and investment strategy, says TJUL is similar to the firm’s other buffered ETFs in that it uses a mix of call and put flex options to set the position of the tracked index—the S&P 500 in this case— and offset losses. 

TJUL aims to encourage conservative investors out of hefty cash positions and back into equities, Urbanowicz explained. As of January, high net worth individuals were holding 34% of their portfolios in cash and cash equivalents, according to Capgemini Research Institute’s 2023 World Wealth Report.  

That’s a significantly higher proportion than in the past five years, when that figure has hovered around 25%. Urbanowicz said one of the biggest challenges financial advisors face right now is weaning clients off chunky cash holdings in a volatile and uncertain market. 

Holding that much cash “is pretty detrimental to long-term returns,” he noted. 

How Buffered ETF TJUL Works 

Urbanowicz explained when setting the options package, the first trade is to get upside exposure. To do so, Innovator buys a deep in-the-money call on SPY, dated two years into the future. The second step is to get the 100% downside protection in place, so Innovator buys an at-the-money put. Hedging costs money, so to pay for that call/put spread, Innovator sets the upside limit by selling an out-of-the-money call at the exact level necessary to pay for the protection it purchased.  

“The beauty of that is we set it on day one. As money comes into fund, we buy that exact same package over and over again. That's how we're able to deliver the defined outcomes,” he noted. 

Positions that are held for the two-year period will get exactly what the strategy says it will do, Urbanowicz says. 

Aniket Ullal, vice president of ETF data and analytics for CFRA Research, concurs that TJUL is designed to attract conservative investors back into equities. TJUL competes with products offered by insurance companies such as structured notes and variable annuities, but buffered ETFs are more transparent, exchange-traded and are fairly cost effective, he added.  

The stated 16.6% return over two years is annualized, minus the expense ratio, and is in line with the historical S&P 500 return, Ullal said: “It’s not for somebody who's trying to beat the market. I think it's more for somebody who's OK with market returns, but is also able to protect downside.” 

No Red Flags on Buffered ETFs

Structurally, Ullal said there are no red flags with these buffered ETFs, as they hold very liquid options, but there are a few things investors should heed.  

Investors are forgoing the dividends associated with the S&P 500, as that also goes to pay for the options package. 

Buffered ETFs in general are marketed as a point-to-point solution: Buy it on day one and hold it to expiration to get the stated return. But investors are trading these vehicles like any other ETF, so their returns will vary, Ullal noted. 

Once the ETF starts trading, it will reflect market movement. Market rallies will narrow the return between the entry point and the cap if investors don’t buy on day one. Additionally, during market rallies, the fund will lag the S&P 500 because of the time value component attached to the options. Also, if the market surges above 16%, holders will miss out on gains exceeding that cap. 

However, Urbanowicz pointed out that with the recent market weakness, investors can buy the strategy below the day-one starting parameters, giving them a chance to offset the ETF’s cost or slightly pad the return. 

Ullal said his biggest piece of advice for investors is to pay attention to market values when they buy a buffered ETF.  

“You need to know where the market is and the point where you’re entering the product,” he said. “Where is the market? What’s the remaining cap?”