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Written by: Marc Odo | Swan Global Investments
The Defined Outcome investment landscape is rapidly evolving, offering new opportunities for managing risk and return with greater precision. As market conditions shift, understanding how these strategies function—and where they fit within a diversified portfolio—is essential.
Over the last several years there has been explosive growth in the category of Defined Outcome Funds. Until October 2024, the category of Defined Outcome didn’t even exist. Defined Outcome or buffered funds were lumped into a broad category called “Options Trading.” However, Morningstar decided to carve out a separate Defined Outcome category as there are now over 350 funds with an excess of $58bn AUM in the category as of December 31st, 2024.
Source: Morningstar Direct.
During the first wave of growth in these products, most funds were variations on these themes:
- Most were based upon the S&P 500
- Most had a one-year time horizon
- Most employed a variation of a “put spread collar” trade
- Most were passively managed, with the portfolio managers following a “set it and forget it” approach.
The basic value proposition of a defined outcome fund was that investors would have partial, but not complete, downside risk mitigation should the S&P 500 sell off. In exchange for limiting the downside losses, the investor’s gains would be capped. If the S&P 500 was up over the one-year period, the defined outcome fund would participate in gains up to, but not exceeding, a predetermined cap.
An in-depth discussion of the put-spread collar trade can be found here. The investor’s primary decision was the risk-return trade-off: larger buffers were associated with more meager caps and conversely, more generous caps were associated with shallow buffers.
Source: Swan Global Investments For illustrative purposes only. This chart should not be the sole factor used in investment decisions.
This basic set-up was also quite easy for the portfolio managers of these funds. Other than managing cash flows, the options in the fund only needed to be traded or “rolled” once a year. In fact, to advertise the buffers and caps of a typical Defined Outcome fund, the managers had to be “hands off” and passively manage the fund. Altering the trades mid-year would change the outcomes.
Evolution of the Buffered ETF (Defined Outcome) Space
The defined outcome space soon became saturated with one-year, S&P 500, put-spread collar products. While these still dominate the market, the beauty of option strategies is there is a high degree of customization available. The second generation of defined outcome funds include the following variations:
- Different underlying asset exposures
- Different tenors or outcome periods
- 100% downside protection buffers
- “Uncapped” funds with unlimited upside potential
- Accelerated exposures
- Fund of funds portfolios
This list is not exhaustive but covers some of the innovations as the Defined Outcome space continues to evolve.
Before exploring each of these variations in detail, it is important to remember that there is no single fund or strategy that will always be “the best.” Different market environments will favor different strategies and individual investors will have different risk-return profiles. In addition, “there is no free lunch”- each structure has trade-offs. The challenge is to find the strategies or funds that are most suitable for the investor’s goals and expectations.
Different Asset Classes:
One of the first innovations was to offer defined outcome funds on asset classes other than S&P 500. It was quite simple to offer put-spread collars on the Nasdaq 100, the Russell 2000 for small cap stocks, MSCI EAFE for international stocks or other broadly used asset classes. The basic put-spread collar structure remained the same; the only difference was the reference asset.
A more recent development has been to offer buffers on individual stocks or assets like Bitcoin. Due to the high volatility of the “Magnificent Seven” stocks as well as cryptocurrency, it is logical that some investors would seek hedged exposure to such assets. The high volatility of such assets also translates into higher caps or sometimes alleviates the need for selling a downside put when building the buffer.
Different Outcome Periods:
This variation is rather straightforward. Rather than a one-year time horizon before the option trades reset, some funds have been released with shorter or longer time horizons.
100% Downside Protection Funds:
Given investors’ aversion to losses and the U.S. market setting all-time highs, there has been a burst of enthusiasm for funds that aim to hedge out all the downside risk of the S&P 500.
It is quite simple to structure an option trade that hedges away the downside risk completely; in fact it is easier than establishing a put-spread collar trade. The trade used in the 100% downside protection funds is known as a collar. With a collar the purchase of the at-the-money put option is subsidized entirely by the writing of a call option. There is no written or short put option that introduces the possibility of losses should the market drop beyond a certain point.
Source: Swan Global Investments. For illustrative purposes only. This chart should not be the sole factor used in investment decisions.
It is true that the more conservative “100% downside buffer” funds don’t have the risk of open-ended losses as there is no written out-of-the-money put option. However, the trade-off is the caps for the 100% downside buffer funds are much less generous. As the old saying goes, there is no free lunch.
A variation of the collar trade can be established where the investor is exposed to the first tranche of losses and is then fully protected afterwards. In this case, the put option is purchased out-of-the-money, like maybe 10% or so. The upside caps would likely be higher for an OTM collar than an ATM collar. This situation is analogous to an insurance policy where the policyholder is responsible for the “deductible” but is shielded from costs beyond that point.
Source: Swan Global Investments. For illustrative purposes only. This chart should not be the sole factor used in investment decisions.
“Uncapped” Buffer Funds:
If the 100% downside protection funds are the most conservative defined outcome funds, then the “uncapped” buffers represent a more aggressive risk profile. On the downside, the value proposition is the same: a put-spread collar protecting against some, but not all, potential market losses.
The upside is essentially the reverse of the standard defined outcome proposition, where the investor receives all of the market up to the cap and nothing beyond. With the uncapped products, the investor gets nothing up to the cap (or “spread threshold”) and everything afterward. There is a hurdle that the market must clear before the investor receives anything, but once that hurdle is cleared, there is no upside limit to what the investor might gain.
Source: Swan Global Investments. For illustrative purposes only. This chart should not be the sole factor used in investment decisions.
An uncapped structure might be suitable for an investor who thinks the market will be “feast or famine” in the coming year. If the markets sell off, the buffer will protect against some of the downside risk. If markets rally strong the investor forgoes the first “tranche” of gains but then has unlimited exposure to the upside. However, if the markets only produce slightly positive, single-digit returns the uncapped structure will likely have disappointing results.
Accelerated Exposure:
Yet another variation to the put spread collar trade is an “accelerated” exposure to the S&P 500 or other reference asset. The basic building blocks are the same: a put-spread collar to hedge the downside, and short, OTM calls that cap the upside.
However, accelerated exposure funds have one additional wrinkle: they augment their upside by purchasing an at-the-money call. This call, coupled with the regular exposure to the underlying asset, gives the fund “double” exposure to the underlying asset for a pre-set range of returns.
Of course, purchasing this additional ATM call is not free. ATM calls tend to be more expensive, and as it’s been said multiple times, there is no free lunch. The trade-off is that the OTM calls written to subsidize the trade produce less generous caps.
Source: Swan Global Investments. For illustrative purposes only. This chart should not be the sole factor used in investment decisions.
In what situations might an accelerated exposure fund make sense? If one believes the market will deliver very modest, single-digit returns in the coming year an accelerated exposure fund might make sense. A traditional, put-spread collar fund might theoretically have a cap of 12%. If the market were up only 5% in the coming year the investor in a traditional put spread collar would only receive the 5% and not maximize the cap. However, an investor in the accelerated exposure fund could potentially receive a 10% return in this situation.
Fund of Funds:
Given the fact that there are well over 350 funds to choose from in the Defined Outcome space, investors can easily be overwhelmed. Rather than face a “paralysis by analysis” situation, some fund companies have rolled out a “fund of funds” structure. In a fund of funds situation, a single fund with a single ticker has exposure to a diversified pool of many buffered funds. These funds are usually diversified across vintages and might be diversified across risk profiles as well.
Within the fund of funds space there are passively and actively managed options. A typical passively managed fund of funds runs a laddered portfolio. A single risk profile is selected (e.g. a 0% to -15% buffer) and the fund of fund equally weights its exposure across the 12 monthly vintages.
Alternatively, there are also actively managed fund of funds. In this situation a portfolio manager would choose across a wider array of vintages, risk profiles, and possibly other features in building the portfolio. The allocations are not equally weighted, but instead reflect the portfolio manager’s attempts to optimize the risk/return trade-off.
The one downside to a fund of funds structure is that one of the key attractions of a defined outcome fund gets muddled or even lost. One of the reasons why defined outcome funds have proved so popular is the high degree of certainty that comes with the passively managed put-spread collar structure. A financial advisor can tell an investor what kind of returns the investor can reasonably expect under a variety of circumstances, with a high degree of confidence. However, by mixing and matching a dozen different defined outcome funds, each with different caps and times to expiration, it becomes much more difficult to provide a simple “here’s what you can expect” analysis. While many investors do prefer the fund of funds structure, once again there is no free lunch.
Summary
As long-time advocates of options and hedged equity, Swan Global Investments is heartened by the surge of interest in Defined Outcome funds. While Swan’s hedged equity solutions tend to be more actively managed than the passive approach prevalent in the Defined Outcome space, the market’s embrace of options has been gratifying.
Swan’s investment philosophy centers on options as a core strategy, enabling investors to define their risk exposure—retaining the risks they are willing to accept while mitigating those they are not. As the Defined Outcome and options landscape continues to evolve, we anticipate the emergence of new and innovative solutions, providing investors with even greater flexibility and control.
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