Advisors that actively deploy exchange traded funds in client portfolios that compared to even just five years, the ETF universe is now home to a dizzying array of products, many of which are increasingly nuanced.
A bygone claim, usually levied by critics, is that the ETF industry is out of good ideas. Issuers pressed that issue and largely proved the assertion false. The product-level evolution in the ETF industry is something to behold and, in recent taken years, it's taken on many forms. That includes new avenues for downside protection.
If the assets under management tallies paint an accurate picture and they do, it's reasonable to surmise plenty of advisors have heard about defined or target outcome ETFs, colloquially known as buffer ETFs. Buffer funds are designed to limit losses on the downside when the funds' underlying markets declines. That's starting point number one for a potentially interesting conversation with clients because so many are interested in upside capture, not mitigating down risk.
The second element of the buffer ETF conversation with clients is the trade-off. It's often said there's no such thing as a free lunch in financial markets and target outcome ETFs are a case study in that. In exchange for limiting downside exposure, users of these products sacrifice some upside capture.
Understanding Buffer Funds
Target outcome ETFs aren't the most complex instruments on the market, but they do possess some intricacies clients may not already be familiar with.
“These funds typically invest in a broad market index along with a standard options collar to limit downside risk,” writes Morningstar's Amy Arnott. “The idea is to provide a shock absorber against a certain level of market losses over a defined outcome period (typically one year). The collar strategy involves selling call options (which limits upside returns) and using the proceeds to buy put options (which limits downside risk).”
Additionally, as the word “outcome” implies, these funds come with expiration dates, explaining why it's common to see months and years in fund names. However, it's the options that expire and new contracts can efficiently be moved into funds, making the products ideal for long-term investors. One more thing: there's not uniformity when it comes to the buffer. Issuers offer a range of these products and the buffers vary in dramatic fashion. However, that's accommodating for advisors because it expands the potential client pool for these funds.
“In down markets, shareholders are only exposed to losses that exceed the buffer. Upside caps vary depending on the issue date and generally increase along with market volatility,” adds Arnott.
Another avenue for advisors to add client value when it comes to defined outcome ETFs is timing. While these funds don't amount to market timing, when the product enters a client's portfolio is highly relevant.
“If an investor buys ETF shares after the beginning of an outcome period, potential return scenarios will reflect prevailing market conditions and current option pricing,” according to First Trust research.
Another Benefit: Reducing Correlations
In addition to devoting time to constructing time to crafting portfolios that are adequately positioned for upside while minimizing downside, advisors have another task: Reducing correlations. First Trust's Buffer ETFs can help with the correlation conundrum.
“On the other hand, the risk management provided by Buffer ETFs is not dependent on historical correlations, but rather on the downside buffer provided by options contracts. By providing layers of risk management, investment professionals may help their clients to feel more confident staying the course when the market sells off,” notes the issuer.
One way of looking at the lower correlations offered by First Trust Buffer ETFs is that advisors can turn to these products over low volatility funds in risk off markets. In fact, data confirm that some Buffer ETFs actually outperformed the widely followed S&P 500 Low Volatility Index with lower drawdowns during the 2020 coronavirus market swoon.
There's no denying lower correlations and drawdowns coupled with enhanced downside protection is a combination many clients will find alluring.
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