ETFs With Downside Protection? It’s Complicated

(Bloomberg Businessweek) -- The promoters of a new kind of exchange-traded fund are making a big promise: Investors can shield their portfolios from some losses and still take advantage of equity bull markets. But these funds are more complicated than the index-tracking portfolios most ETF buyers are accustomed to.

Known as defined-outcome ETFs, they don’t buy stocks directly. Instead they use options contracts to deliver the price gain or loss of an index such as the S&P 500 over the course of a year, up to a preset cap. For example, one S&P 500-based defined-outcome ETF—called Innovator S&P 500 Buffer ETF-October Series—can’t rise by more than 14.12% above it’s starting point over 12 months, before fees. If the S&P actually loses money in that span, the ETF’s losses are buffered, shielding investors, before fees, from a price decline of as much as 9%. They’ll lose money if the market falls by more than that.

The funds come from Innovator Capital Management, co-founded by Bruce Bond, a familiar name in the ETF business. Two decades ago, Bond co-founded PowerShares, an ETF manager that’s now part of Invesco Ltd. Downside protection isn’t easy to sell in the midst of a very long stock rally. But Innovator got a bump after December, when the S&P 500 index briefly dropped to the brink of a bear market. Investors began pouring money into Innovator’s ETFs. Assets in the products have increased almost tenfold this year, to $1.6 billion. Bond says his funds provide certainty about potential losses that’s hard to get elsewhere. “Everyone in the ETF marketplace today is, basically, what I call naked,” he says. “They really don’t have any type of protection.”

The basic idea behind the funds isn’t new. They look a lot like structured notes, which are created by banks and sold by financial advisers to individual investors. The notes promise buyers returns that are linked to the performance of other assets, such as stocks, currencies, and commodities, with some protection against losses. But they can be expensive, difficult to get out of, and complicated—it can be hard to see all the risks, or to tell if the buffer you’re getting is worth the potential gains you’re giving up.  “As soon as you see complexity, you should run as fast as you can,” says Larry Swedroe, chief research officer at Buckingham Family of Financial Services, speaking of such investments. “Because you have to ask: Who is the sucker at the table?”

ETFs, by contrast, have become popular in recent years, in part, because they’re generally straightforward. They have a constantly updated price anyone can see, and can be bought and sold easily, like stocks. “What the ETF does is get rid of a lot of things that people didn’t like with structured products,” says Bond. But defined-outcome ETFs have some wrinkles that could trip up investors who don’t understand them. For a start, the funds' investments have a specific lifespan. Each fund is named for the month when its cap and buffer for the next 12 months are determined. (There are different versions of the funds for various start dates.) After a year, the fund resets. 

The return caps and buffers are based on what happens if you hold the ETF starting from immediately after its launch or its latest reset, and hang on for a year. If you buy later, you could get a different return—and different levels of protection—based on how the market has moved since. If the market has gone up, for example, the fund will lose some of its return potential, and it will also have to lose some money before the buffer kicks in. Innovator updates on its website how the return potential of each fund has changed. 

Most of the funds carry an expense ratio of 0.79% of assets per year. (Caps and buffers are calculated before expenses, so the cap on the S&P 500 fund with 14.12% cap is effectively 13.33%.) This makes the funds inexpensive compared to some structured notes, but more expensive than a plain-vanilla S&P 500 ETF, which can be had for less than 0.05% of assets per year. Unlike ordinary index funds, defined-income ETFs track only the price of an index, not the dividends. For investors in a normal S&P 500 fund, dividends have lately added about 1.9% to annual returns. 

When Victoria Bogner, the chief executive officer of Affinity Financial Advisors, first heard of Innovator ETFs, she says she spent hours on the phone with the issuer struggling to grasp how they worked. She says she has to constantly update a spreadsheet she built to keep track of how they’re performing. But the Lawrence, Kan.-based adviser has few regrets about putting some of her clients into them. “I know exactly how much risk we’re taking,” she says. “And that is really powerful.”

Swedroe, at Buckingham, isn’t convinced the funds are big improvement on structured notes. “These are a better version of a bad idea,” he says. But the real question Bond and his funds will face may be whether they can stand out in a field of ETFs that’s gotten crowded. Investors worried about market risk have lots of other alternatives—from switching money into bond funds to buying index funds that track less risky stocks. “It’s not exactly prime real estate,” says Ben Johnson, head of passive-strategy research at Morningstar Inc. “That waterfront has long since been covered.”

To contact the editor responsible for this story: Pat Regnier at pregnier3@bloomberg.net

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