Are Buffered ETFs a Good Way to Protect Capital?
This is a difficult time to invest. Stock market valuations are at very high levels. Bond yields are extremely low. The world is uncertain, as has been exposed by the continuing pandemic. What is an investor to do? Many investors are taking on additional risk to try to earn a higher return in this low-return environment. Others are eschewing risk and waiting for a better entry point while watching inflation erode the value of their savings. In this environment, some alternative products are becoming popular. One such product is a buffered fund. This links returns to an underlying index, but caps the maximum gains and buffers losses. Insurance companies have long offered equity linked products that mimic market returns up to a point, but do not participate in market losses over a given period of time. Now, a similar strategy is offered through ETFs. These funds offer participation in the upside of an index to a point, while absorbing or “buffering” losses to a point. Innovator ETFs is a leader in this space and has quickly grown to $6B under management through offering a suite of so-called “Defined Outcome” ETFs on various indices. Innovator is certainly innovative in creating new products to offer. It is even launching a hedged Tesla ETF. Buffered ETFS are presented as bond alternatives due to their ability to protect capital in a down market. This article analyzes the Innovator Defined Outcome S&P 500 products, but the conclusions should hold for other similar products. I argue that these products are likely not the best way for investors to manage their risks.
How Do These Products Work?
In general, buffered ETFs work by using options contracts to get exposure to an underlying index and then using an options overlay to achieve the required buffers. An out of the money call option is sold at the upside cap, which provides funds to buy a put (roughly at the money) to protect the downside. Because total downside protection would be too expensive, an out of the money put is sold to help pay for the at the money put. As a result, protection disappears once the buffer is used up. Investors could implement the same option overlay on their own portfolio and avoid paying Innovator or other providers the hefty fee. The buffered funds provide convenience and an ETF wrapper, which is more tax efficient. Further, many individual investors are not proficient in using options to hedge a portfolio.
Advantages of Buffered ETFs
Buffered ETFs lose less when the underlying index declines. They reduce volatility in the portfolio, making returns over a period of time more predictable. Smaller losses mean investors should not need as long to get back to even after a decline. The ETF structure allows the investments to be ongoing and tax-deferred, as opposed to buying options contracts directly.
Disadvantages of Buffered ETFs
First, the name, “Defined Outcome ETFs” is somewhat of a misnomer. While the maximum upside in a year is defined, the downside is only hedged to a point. A 9% buffer means that the first 9% loss is protected, but investors will participate in losses dollar for dollar after that. This leaves investors unprotected just as the index is entering correction territory. Even many conservative investors can handle a loss of around 10%. It is the uncertainty of how much deeper the losses can go that drives people to sell out. As such, these products are unlikely to solve the behavioral problem of buying high and selling low.
Second, the “Defined Outcome ETFs” are based on the price return of the index, not the total return. Currently, the dividend yield on the S&P 500 is only 1.3%, but historically, dividends have made up a more significant portion of the total return of the index. Even 1.3% is a significant drag over time, and when added to the expense ratio of the ETF, constitutes a drag of over 2% per year vs. a low-cost S&P 500 ETF. In the twenty-nine year period from 2/1/93 to 2/1/22, SPY, the S&P 500 index fund, averaged a 10.4% compounded average return. The price index (stripping out the dividend) earned only 8.3%. This means $1 would have turned into $17.49 if invested in the SPY with dividends reinvested, but only $10.20 without dividends. If a 0.75% fund fee is subtracted (roughly the difference between the Innovator fee and the SPY fee) the end result is only $8.25, or half of an unmanaged, dividend reinvested SPY investment.
Third, while it may sound acceptable to cap annual returns around the average return of the index, actual annual returns are rarely close to the average. Much of the long-term return from the index comes from very good years. The Innovator funds are designed to protect against a certain level of decline, and the cap is based on current options pricing. As such, it is not feasible to test exactly how this strategy would have done, but we can approximate. For instance, using the 29 years of price data on SPY, a 9% buffer with a 12% cap and a 0.8% annual fee would have returned 4.5% compounded. This is 5.9% less than a buy and hold SPY strategy. This is a 57% reduction in annualized return (and a 79% reduction in ending value). There is a corresponding 59% reduction in volatility, but the maximum draw down of -36.5% is not that much better than the -43.4% max annual drawdown of the SPY. (This is using annual return data with a Feb 1 start date. Other monthly start dates would have different data.) Since the Innovator Buffer ETFs offered now have a cap ranging from 12% to 15% over the next year, I tested the 15% cap, which would be the most favorable for investors. Applying this back to 1992, the return would have been 5.7% annualized, an improvement of 1.2% from the 12% cap, but still 4.7% less than simply buying the index fund. The “Power Buffer” ETFs protect against a 15% drop in the market and have an average (over the next year) upside cap of 9%. Using these parameters for our test yields an annualized return of 3.7%. Return is roughly cut by two thirds, while max draw down declines by less than a third (43.4% to 30.5%). Finally, the “Ultra Buffer” ETFs protect a 30% drawdown in the market, with a cap of about 6.5%. This would have yielded 3.4% annualized return. One dollar invested for twenty-nine years would have grown to $3.65 vs. $17.49 in the index fund. These tests are approximate, and they are based on the last twenty-nine years of actual data. The future could look different than the last few decades. The point is that looking backward over a reasonable period of time, using options to hedge a portfolio has been an expensive way to manage risk. As the old adage goes, “There is no free lunch on Wall Street.”
While buffered ETFs do reduce downside risk and price volatility, they do so at a heavy cost to returns. Better alternatives are beyond the scope of this article, but if history is any guide, these are not good tools for long-term investors in accumulation phase. Further, products like the Innovator Defined Outcome ETFs® leave investors exposed when they are most likely to be worried – after the market has made a move lower. Investors would be wise to look for other ways to reduce risk. Even holding 40% of a portfolio in a zero-yielding safe asset and investing the rest in an index fund would have had higher returns with lower risk than using the strategy employed in the tested ETFs with their current fees.
Capul, J. (2022, February 2). Like Tesla but fear a correction? Innovator ETFs Trust is working on an ETF for you. Retrieved from Seeking Alpha: https://seekingalpha.com/news/3794922-hedged-tesla-etf-aims-to-invest-20-in-call-options-and-us-t-bills-to-soften-downside?mailingid=26571359&messageid=2900&serial=26571359.12136&utm_campaign=rta-stock-news&utm_content=link-1&utm_medium=email&utm_source=s
etf.com. (2022, February 2). Innovator ETF Channel. Retrieved from etf.com: https://www.etf.com/channels/innovator-etfs#:~:text=Innovator%20ETF%20Channel&text=With%2084%20ETFs%20traded%20on,average%20expense%20ratio%20is%200.80%25.
The views expressed are the views of Jacob Rothman on behalf of Rothman Investment Management, LLC through the period ending February 2, 2022, and are subject to change at any time based on market and other conditions. No client or prospective client should assume that any such discussion serves as a substitute for personalized advice from Rothman Investment Management, LLC.
The information herein should not be considered a recommendation to purchase or sell any particular security. The securities and strategies discussed herein are meant to be examples of Rothman Investment Management investment approach but do not represent an entire portfolio or the performance of a Fund or Strategy and in aggregate may only represent only a small percentage of the portfolio holdings. It should not be assumed that any of the securities discussed herein were or will prove to be profitable, or that the investment recommendations or decisions made by Rothman Investment Management in the future will be profitable. Further, nothing in this letter should be taken as financial advice.
The benchmark for US Large Capitalization stocks is the S&P 500, a market capitalization weighted index containing the 500 most widely held companies.
Past performance is not indicative of future results. Therefore, no current or prospective client should assume that future performance of any specific investment, investment strategy or product made reference to directly or indirectly in this letter or indirectly via a link to an unaffiliated third party web site, will be profitable or equal the corresponding indicated performance levels. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client or prospective client’s investment portfolio. Historical results for investment indices and/or categories generally may not reflect the deduction of transaction and/or custodial charges, nor the deduction of an investment management fee, the incurrence of which would have the effect of decreasing historical results.
 (etf.com, 2022)
 (Capul, 2022)
 This is because they are based on an options contract tied to the index price rather than holding the index.
 I use SPY because it has the longest history. Other S&P 500 ETFs have lower fees.