ETF Investing Guardrails

(For more on this subject join us Tuesday, December 10 at 2 p.m. ET for our free webinar, “Playing Defense: Under the Hood of Defined Outcome ETFs.”)

If you’ve tuned in to any of my weekly “Live Chats,” or seen me on a screen or a stage in the past year, there’s a reasonable chance the topic of so-called defined outcome ETFs has come up.

This isn’t an accident. I genuinely believe this new category of products (currently offered by Innovator and First Trust) are some of the most useful products I’ve seen in the past 25 years for one simple reason: Not everyone wants the risk/reward trade-off present in the equity markets exactly as offered by the ghost of Adam Smith.

What The Heck Are These Things?

I often use the metaphor of a platypus when describing ETFs. Platypodes aren’t one kind of thing or another, to the casual observer: some combo platter of weird dog and ill-formed waterfowl. ETFs, being both a bit like stocks and bit like funds, are similarly “in between.”

The metaphor carries extra weight because platypodes are poisonous if you’re not careful, and indeed, there are dark corners of the ETF world where not knowing what you’re doing can get you into trouble.

Defined outcome ETFs put the platypus to shame: They provide equity-linked exposure, but don’t invest in equities. They use derivatives, but in the opposite way most investors think of derivatives: to manage risk, not provide speculation or leverage. They offer seemingly simple patterns of return, but are actually quite complex under the hood.

At the simplest level, defined outcome ETFs offer you the upside return of some index up to a certain cap, and in return for accepting that cap, they give you some level of protection to the downside. In the simplest example, if you buy the newly launched December-linked Innovator S&P 500 Buffer ETF (BDEC) right now, you’ll cap your upside between now and next December at 13.35%, and in return, you won’t experience the first 9% of a decline.

One of the reasons I love these products is because they pass the “mom” test. My mom is not a sophisticated investor, but she’s a smart person. I explained these products to her using the same words above, and she completely got them. Market goes up 20% in the next 12 months? Sorry, you only get the 13.35%. Market goes down 20%? You only go down 11%.

Past The Headline

Where things get a bit more complicated is in the details. Because these products use “Flex options” to get this cool exposure, they really have to be tied to some calendar date at which point the series has delivered on its promise.

That’s why these products are relaunched each month. You can buy any month’s fund at any time, but you’ll need to look up the cap and buffer as of the date you’re investing.

So for example, if I bought the June series of the above product, well, the June product is already five months old, and the market has been up a bunch, so the cap is largely “used up.” Today’s buyer would get a cap of 5.95%, but the buffer wouldn’t kick in until the market falls 9% (giving back that cap headroom as it goes), at which point the buffer would kick in, protecting me from further losses.

Investing With Guardrails

Complicating things further, there are different buffer/cap combinations available for each month, and different indexes tracked (Innovator tracks the S&P 500 Index, First Trust tracks the SPDR S&P 500 ETF Trust (SPY) itself, and there are international versions as well).

This can lead to those “mom” conversations going off the rails quickly, because these funds can sometimes appear quite complex, when in fact the value proposition is quite simple: investing with guardrails.

And frankly that’s irritating, because as I said, I think these products solve real problems for average investors—investors who want to stay invested in the market, but who want assurance it’s not all going to go horribly wrong.

Get Smart

There are, of course, other nuances: Different approaches here have different tax implications; the indexes tracked are generally price indexes (because that’s what the options markets track); and thus you need to consider those in the “upside” you’re getting—and of course, nothing’s ever free.

But I think you owe it to yourself and your clients to get smart about these types of products. If ever there were a case where the smart financial advisor can provide real value to their clients by wading into the math, this is one of them. It’s worth digging into company websites.

I’m also going to grill one of the companies involved, Innovator, next Tuesday, December 10 at 2 p.m. ET during our free webinar, “Playing Defense: Under the Hood of Defined Outcome ETFs.”

I’ll be asking the hard questions not only of the founder of Innovator, Bruce Bond, but Wally Brown, an advisor with GCG Financial, who’s using these types of products in his firm’s day-to-day practice. I’m eager to hear Wally’s take in particular on how these products are fitting into client portfolios, ’cause what do I know?

I hope you’ll join me for the conversation and ask all the tough questions you have as well. Registration is complimentary. Sign up here.

Dave Nadig can be reached at [email protected]