Inside Perks, Downfalls of Defined Outcome ETFs

If you’re an advisor that hasn’t heard about defined outcome exchange traded funds, chances are you will and there’s data to confirm as much. A the end of 2018, the combined assets under management for these products was just $183 million. By January 2023, that figured swelled to $22 billion, representing exponential growth in just over four years.

That confirms more asset allocators and investors are embracing these funds. One reason for the popularity of these products is that they’re easy to explain to clients. Put simply, defined outcome ETFs provide some upside capture while providing downside protection.

Said differently, the end user of a defined outcome ETF is exchange some upside potential for a downside buffer. Hence, these funds are often referred to as “buffer ETFs.” In fact, that’s the branding used by issuers such as Innovator ETFs and First Trust.

The terminology “defined outcome” is derived from the fact that these ETFs have a target-date element to them in that there’s an expiration or reset date. For example, the Innovator U.S. Equity Buffer ETF – December resets in December. That’s an important part of the defined outcome ETF equation, but there’s much more to the story.

Examining Costs

As advisors know, costs are vital considerations when evaluating any fund – active or passive, ETF or mutual fund. On that note, it cannot be ignored that, as Morningstar points out, the average annual expense ratio on defined outcome ETFs is 0.81%, or $81 on a $10,000 investment. That’s high compared to the vast majority of ETFs.

That expense ratio is relevant for another reason. Many defined outcome ETFs follow well-known indexes, such as the S&P 500. Thing is the traditional products linked to those benchmarks are usually among the cheapest ETFs an advisor can find. That’s not the case with buffer funds.

“Downside protection comes at cost, though. What investors save in down markets, they lose in market rallies, higher fees, and lost dividends. Defined outcome ETFs afford their downside protection by capping the fund’s upside return. During periods when stocks rise, investors consistently miss out on a portion of returns,” notes Morningstar.

Obviously, high fees further pressure defined outcome ETFs’ performance. Options explain why buffer ETFs carry high fees. These funds are rooted in options strategies. Hence, the reset dates are essential.

“Defined outcome ETFs set their outcomes based on how options will be priced at expiration, when no uncertainty about the underlying security’s price remains. But knowing the dynamics of time value and volatility will help investors know what to expect from the performance of these ETFs after their options exposure is set and before they expire,” adds Morningstar.

In other words, the mechanics of defined outcome ETFs can be explained, but there’s a chance this is wonky subject matter that will fly over the heads of many clients. That’s not an insult. It’s reality.

More Considerations, Confusion

Another consideration for advisors when it comes to buffer – one that might confuse clients – is that not all defined outcome ETFs are structure the same way. Some, even in the same fund families, offer varying degrees of upside capture and downside capture. As a result, some buffer ETFs feature numbers in their titles, say 80/20, to reflect the fund’s upside limits and downside protection offered.

Using 80/20 as the example, say the S&P 500 rises 10%. The hypothetical buffer ETF will rise 8%.The downside protection kicks when the price of the long put options held by the fund turn in the money. Another potential source of confusion for some clients.

“Upside Cap and Partial Upside Exposure strategies share the same downside protection profile but offer different options when the index rises. Upside Cap ETFs fully replicate the index’s positive return up until the cap. On the other hand, Partial Upside Exposure ETFs increase at a slower rate but without a cap on returns. Once the index moves past the upside cap, the Partial Upside Exposure funds continue to capture a portion of the index returns—80% in this case—while the capped funds fully miss out,” observes Morningstar.

It’s also worth remembering that one of the primary reasons money managers and clients seek downside protection is elevated market volatility. However, when that condition sets in, guess what happens? Options prices rise, making the at-the-money options in partial upside exposure buffer ETFs more expensive.

One More Point to Consider

Another downside of defined outcome ETFs is that these products, due to the aforementioned mechanics and others, don’t allow for dividend reinvesting. Obviously, a standard S&P 500 ETF does that. That’s another drag on returns.

Oh yes, returns. Use 2021 – a strong year for stocks – as an example of the downfalls of defined outcome ETFs. In that year SPX (S&P 500 Total Return Index) and SPY (the biggest S&P 500 ETF), soared, leading to some disappointment among buffer ETF holders.

“All upside caps were hit as S&P 500 Price-Return Index SPX and SPY returned 26.89% and 28.59%, respectively, in 2021. Funds with the most protection returned less than 10%, not even 40% of the index’s return. The rule holds: The more downside protection provided, the more upside these funds gave up,” concludes Morningstar.

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