Should You Invest in Defined Outcome Buffer ETFs?
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Walk the money for the rest of us. This is a personal financial on money, how IT works, how to invest IT in, how to live without worrying about IT. And your host David stein today is upset. Four eighty five is title. Should you invest in the find outcome buffer etf, one of the things that we do at money for the rest of us is monitor new investment products that may help us in managing our investment portfolio, hopefully generate higher returns at lower risk. Over five years ago, in plus episode to forty, we looked at one of these new investment products.

What often do those more detailed may be technical discussions in are are plus episodes that we released to members of our money for the rest of us, plus community, just because sometimes that works Better to get in the weeds in those episodes. So this is a brand new product. IT was called the innovators S M P five hundred ultra buffer etf.

IT was the january series, and I had the ticker U. J, A. N. This was, as far as i'm aware, the first r or defined outcome etf released a defined outcome exchange. The fan also known as a buffering etf.

It's a publicly traded security IT has a fixed maturity date in that the time period the outcome period is said, the etf will provide exposure to an equity market index could be the S M P five hundred der, could be an etf that tracks the S M P. Five hundred or the next act one hundred. You get exposure to that index, the upside up to a cap, but you also get some protection on the downside, and that's the downside buffer.

So there's two components to these defined outcome. E, T, S. There's a return buffer that protects investors from losses up to some levels.

And there are many variations on how these buffers work. For example, the innovator U S. Equity alter buffer etf ticker is U J U. N. It's offering a buffer to investors against losses of a negative five percent to negative thirty five percent.

So the investor will suffer the the first five percent of losses and then nothing beyond that until the losses in the S. M. P.

Five hundred exceed thirty five percent. Now this is for the outcome here. This etf, the most recent outcome is, is june first twenty twenty four through may thirty first twenty twenty five.

At that point, existing investors will roll into the new outcome period, which would be from june first twenty twenty five through may thirty first twenty twenty six. Now innovator has a number of different months. The first one we looked that was the january series that have a june series.

And each of those then there's A A certain buffer that they're willing to protect. But in order to get that protection, that insurance, there's a give, and the give up is the cap. So these defined outcome etf are essentially combination of owning insurance for downside protection that is financed by selling insurance by capping the upside return.

For example, the innovator U S. Equity alter buffer etf U J, U N. For this current outcome period, the cap is fourteen point three percent, which means investors will earn the first fourteen point three percent Price return, a Price appreciation on the spider S M P five hundred etf, which is the underlying etf being tracked.

But anything above that, they wouldn't be able to participate because the etf sponsor in structuring these etf uses flex options. And these are a customizable options that are guaranteed by the options clearing corporation. But they're very specific for this outcome period.

So much protection on the downside verses a cap on the opposite. Outcome based products have become incredibly popular. Total assets have grown to forty six billion dollars.

They've tripled the asset size since october twenty two, according to bloomberg intelligence. That's about much invested in these outcome based buffer etf as there are invested in the new spot bitcoin. E T S I shares one of the largest etf providers in the world, if not the largest, just announced their first buffer etf.

It's the ice. She's large cap max buffer. June etf ticker is M A X J. The outcome period is july first twenty twenty four through june thirty, twenty, twenty five. That's the one year period they're offering one hundred percent protection on the downside to any losses below the the starting Price. But cap is lower.

The upside cap is ten point six percent and the Price appreciation above that the investor wouldn't participate that's in in that show is how these are structure. We're going to look at what returns have been. And should we are, how would we even use these in our portfolio.

But there are those two component. You get the protection on the downside, some level protection, they're giving up the cap on upside, and there have been other variations before we continue. Let me pause and share some words for one of this week.

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Had a net sweet dot com slash David that's net sweet dot com lash David, net sweet dot com slash David. We discussed an epsom three twenty one of the podcast how to analyze complex investment innovator had introduced a triple stacking er etf where you got three times the upside on the S N P R, the last act one hundred, but only once on the downside. So you get one time exposure on the downside, potentially three times on the upside.

Those proof did not be very popular. So innovator shut them down at the end of last year. And at the time, they had only about fourteen million dollars in assets.

They have another version that we discussed, an episode three twenty one, that they now call the innovator. U. S, equity accelerated nine buffer etf tickers.

X, B, J, L. There you get two times the upside return, and then you're protected against losses for the first nine percent loss. The S, P, course, the cap is twelve point three percent.

You get two times the upside up to the cap, which is which is so frustrating about them is there is no free lunch. If you want protection on the downside, insurance IT has to be paid for and it's paid for by capping the upside. So if you look at the return historically for the innovator U S, equity accelerated nine buffer etf.

X, P, J, L. Did IT return two times the upside on the S P. no. Since inception, returns been three years. Overall return on an analyzed metaphors, expense ratio for the innovator etf is zero point seven nine percent, for the new I shares etf is zero point five percent, but four X P G L, the analyze return was seven point nine percent IT lagged the Price return of the S M P five hundred of eight point three percent. So I didn't return double the upside.

If we look at the total return of the mp, which includes the dividends, because none of these t fs include divided, there is no cash flow associated with that is all because it's option based, its Price appreciation underlying referenced tf for index. So the total return of the S M P five hundred over the past three years has been ten percent analyzed. Now the volatility was less, about a stand deviation of nine and a half, about half that of the S M P over the past three years, which was seventeen point eight.

Now that's key because what we really want to look at is what's the return that we're getting, how much volatility do we experience to get that return, both in terms of as measured by stand deviation but also the maximum drawed down. And that's what's so interesting about looking at these buffer etf now because they have over five years worth of history because even though the the the outcome periods of one year, the E T. S.

Continue, they just start a new series, a new one year with a new buffer level and a new cap. So if you had invested in the regional buffer etf, the U S. Equity alter buffer etf, the january series U J A N, the one that we featured in that plus episode a month after that was released, how has IT performed well since inception is returned? Seven point four percent analyzed, pretty good.

If we look at the return of the S M P five hundred on a Price space that's been fifteen point two percent and a total return, the S M P, including dividends with seventeen point one percent. So the buffer etf, the january series uga return forty three percent, the total return of the S N P, IT return, forty nine cent of the Price return. And IT revolution late at seven point one, was about thirty eight percent.

The volatility of the S N P, which was around nineteen. So not bad. The maximum draw down during that period was thirteen point seven percent. That was the biggest lost and investor would have experienced in holding that, particularly etf verses had they held the sp. There was a thirty three percent laws, and that was during the pandemic.

So there was some protection on on the downside so that such january series, the june series, which came out six months later, returns weren't quite as good. Five and height percent analyzed returns since inception, IT achieved about thirty percent of the total return of the S N P and experience forty one percent of the volatility. Its maximum draw am was also thirteen seven, essentially the and if we look at the these innovator series, they're capturing, let's call IT, forty percent of the return of the index for about forty percent of the risk.

I always depend on the series of time frame. If that's the case, we could replicate the returns by just investing a lower amount in the S M P. We could put, for example, thirty eight percent in the S M P, five hundred sixty two percent in cash to chose the eyes shares floating rate income fund.

And if we done that and held IT over five years, we would have returned seven point nine percent, about a half percent more than. And the etf, did you, jan, the innovator buffer etf. And so we're going to take a look at how we use this or should I be used.

But there is in a free lunch or giving something up high returns in order to reduce the risk. There are some other potential risk. If you look at the perspective, the returns are not guaranteed.

They are using options and so they are not a guarantee that you don't suffer losses. That's how the structured, but options mayor may not work in the way IT was designed. The other risk is really the fees, the fact that the fees are based on and outcomes are based on holding IT for the entire year.

But if you exit early, the return of the etf might not actually equal the return of the underlying index even if there was in a loss. So if we look at, for example, just that june series that launched a couple weeks ago, the find is up three point two percent since that series started june first. But the references etf by the S P five hundred etf up five and half percent.

And so that difference would be partly how the fees have analyzed because it's so early in a series that also could be based on the voluntier ity. So there is no guarantee that the expectations of these buffer E T S will be met. I saw another paper by a friend of my pok kroc, and he did a simulation analysis, ten thousand simulations.

He was modeling a sort of a metic buffer etf, where the market the average return was eleven percent and the standard deviation was fifteen percent. This would be a money carless simulation. Then the hypothetical buffer etf, the cap would be ten percent with a zero percent floor.

So you would have buffer against all losses on the S M P. So this is similar to the new eyes shares buff. Er T, F, that's coming out. Max J, M A X, J, what a crosbie find in his analysis. Well, I did avoid the market crashes and drawdowns about five percent of the years in the ten thousand.

In your simulation, the market in that one year period had a lost greater than fifteen percent, and there were three years where the loss was greater than fifty percent. And that that is a big risk with stocks. A potential fifty percent drawdown will get back to that later in the episode.

But there was a give up. So the average return of in his simulation for the etf was six point two percent versus the market return of eleven point six percent. So in that scenario, IT captured just about fifty percent of the return of the S.

N. P. And his nativity was much less at at a three percent statia ation. Versus fifteen for the market.

So that makes me think that maybe the way that eyes shares is creating their new one where your buffer is any loss in the S M P below the reference Price is potentially a Better product and in that IT reduces all the downside. One of the frustrations i've had with the innovator buffering tf series is the way they structure their buffers. Now I think they now have somewhere.

It's all the downside protection and and obviously, the cap is gonna be lower if you're protect against all the downside. But those initial series that came out in twenty nineteen, you were exposed to first five percent of the losses, first ten percent, and then you weren't exposed, but then you were exposed to losses greater than thirty five percent. And from an analytical perspective, that drove me nuts.

If I get protection, I went protection on the downside, all of IT. And that's how the new eyes shares is being structured, and I believe innovator actually has some like that. Before we continue, let me pause and share some words from this week.

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David, couple years ago and maybe is about year ago, I met with a financial advice that we had A A conference call and he loves using these products for his clients. Before the etf, the brokers have always made these available. They were separate contracts.

And even as an institution, al investment advice, I ve found them really chAllenging to analyze because didn't participate in the dividends and was hard to look at how they return, which is why it's so nice that we've have five years of history than more than five years with these innovator etf to be able to say, okay, we're onna get forty percent of the return of the S M. P. For roughly forty percent of the risk.

So why would you use those? Well, here's a reason not to use them. This is a quote by the co founder of innovator E T S.

Bruce bod. He said, I think people are nervous about the market. They don't know if they can trust bonds or equities. Most people are afraid to get in because they think as soon as I get in, this thing is going to crash. That is not a good reason to invest in buff for etps.

If you have a pool of money and you are worried bad a crash, you don't put IT all in in stocks at once. You can dollar cost average in. But if you don't trust bonds and stocks, maybe because an investor doesn't really understand them, why would you go into a product that's even more complex with caps and buffers and option strategies in higher fees? We need to understand what we're investing in.

And that's why, for example, on an acid camp where we spend a great deal of time understanding the drivers of the stock market, the dividends, the earnings growth evaluation and do a monthly webinar on that because we use these tools and how we invest. And you can learn more about asia camp. At asia camp, not come, but that is our tool to understand the underlying drivers of the stock market in detail.

We cover forty six stock indexes, and we're working on the bond side, and hopefully, we'll release that by the end of the year. Then who is head of client solutions that morning? Star says we know over long enough periods of time that markets tend to go up.

And what you're giving up is going up every bit as much as a market does over longer period of time. He's referring to the fact that there cap and we're giving up the upside above that cap. Johnson continues.

Now if you're willing to make that trade in exchange for a degree of comfort for being able to sleep Better at night, then so be at i'm not sure we should be making that trade. The jury is still out. Causal simulation makes them look much more attractive.

But the actual return so far for the buffer E, T, it's a top. We could achieve a by having a lower allocation to stocks. The reason why these products exist is because as humans, we have loss aversion.

Loss aversion was a concept developed by Daniel conomo and aims diversity in the field of behavior economics. One of their, their payment phrase, this is losses loom larger than gains. Loss aversion describes how the pain we feel from losing money is greater than the pleasure we get from an equivalent game.

Losing one hundred thousand dollars feels way worse than winning one hundred thousand dollars. And we hate these losses so much that we don't even want to recognize them any duke. In a discussion, we headed back, and episodes of six talked about how we like to turn unrealized games and to realize games because then we want.

But if we have an unrealized loss, we don't want to sell IT because then that would be a realized loss because we have these these cognitive ledges is mental accounting, but we have this loss of version. We feel worse when we lose money, and we're willing to buy insurance to protect against. The question is, what are we giving up to do that? Condemn and diversity in one nine hundred and seventy nine pp, or then introduce something called prospect theory mentioned that how we perceive losses isn't necessarily always an absolute ss.

There's a reference point. IT could be how much wealth we have. IT could be how much wealth our neighbor has. If we have one hundred thousand dollars, we'll feel way worse.

If we lose one hundred thousand dollars and our network was two hundred thousand dollars, where we lost half our network. That way worse than is, we lost one hundred thousand dollars and we had ten million dollars in that worth. Now partly that due to our loss capacity, which is different than loss aversion, lots of versions of feeling a feeling of regret for having lost money.

Lost capacity is our ability to withstand the loss. Will we be ruined if we lose half a network? But IT is very subjective. We could feel loss because we missed out on something or we feel loss because we feel like we're not keeping up with our neighbor.

Now there's another behavior finance topic that Richard della introduced called narrow and narrow framing is when we evaluate risk separately from other risks. So we get so focused on one risk that we ignore the other ones. For example, we could get very focused on losing money in the S P.

Five hundred, and that's our biggest concern. I just hate the feeling of losing money in stocks, but we don't put IT in the context we don't and IT out and think about what what about overall portfolio? What percent r stocks of a overall portfolio?

No reframing would be focusing on a negative return rather than how much compounded wealth we have after saving for thirty years. That's a broader view. That's not narrow framing. Now we've done a number of episodes on should we be a hundred percent invested stocks and in the risk of being one hundred percent exposed stocks.

And the biggest risk is the big drawdowns, those three years in catrock y simulation, fifty percent loss, the sixty five percent loss in the stock market in two thousand and eight. And there is some benefit to protecting against those big losses is called volatility drag. Just the mathematics, we lose fifty percent of our portfolio.

We have to gain one hundred percent to get back. We always have to look at what is the cost to that protection. Heads from manager mark spits nego rote, a book on this couple years ago called safe haven investing.

And he went through all the mathematics, and he made the point that the most important thing we should be concerned about is our geometric cumulative return over time and how our wealth is compounded. It's that and a period wealth that matters how IT compounded, not any given year, but he also shown mathematically by reducing the downside, we can have higher compounded wealth depending on how much we paid further protection. And he he looked at a number of asset classes is gold t bills.

Well, we had to the portfolio that increase are end up period wealth because we reduced the downside and generally know what happens with most assets is by allocating more to bonds or cash, we reduce the risk and we reduce the return. And that's what we've seen with the buffer. E, T, S, yeah, we get some downside protection, but we also lower the return because of the cap and because we're not giving the dividend.

And IT IT tends to be at least based on history. If we got more of the return, we captured eighty percent of the return with only forty percent of the risk. That be great.

But the historical returns show that we're basically lowering the return by the same amount as we're reducing risk. And at least for the one series, we actually captured less of the return, thirty percent for forty percent the stock market risk. So there is a potential, if we could find a true hetch, that we reduce the downside without reducing the return out.

But snake s as he has one, but he'd ever, ever tells us what is, is some type of insurance product. Now there's another problem with these buffer etf is that the stock market is positively stewed, which means that there are extreme upside events that bring up the average. We discuss positive stuss a few episodes ago.

We want exposure to those extreme upsides. And by having a cap for these buffer etf, we miss out on the upside in exchange for some protection on the downside. So our question is, one is that cost too high? I wish these products would work Better one way.

I consider that, that makes sense. And I are linked to a really technical paper on options that looked at these buffer E T S. And and they point IT out is because does these buffering tf have a certain outcome periods over time?

The market is moved. So the series that starts june first, twenty twenty four, were now mid july, which means that the cap could have been used up because the market IT has gained since then. And IT also means that the amount that we lose before the buffer chips in is greater. And so in analyzing these etv s unless you go in day one, you always have to look at how much does the market have to fall off before the buffer kicks in and how much of the caps is used up.

If the market is over the cap, then there's no reason by the etf because then you don't have any update ders downside and they point IT out the mathematics of options that you get time decay and IT might make sense to exceed a buff for etf early and moving into another one that has a higher cap and has reset the buffer at a fire level and that that's where maybe there's an active strategy and maybe there there isn't etf. I don't know is there need to have there should be or probably will be that actively moves in and out A A buffer etf in order to maintain lucking games, essentially raise the cap and raise the buffer. And so is aren't necessary something we can just let ride IT advantages to sort to keep looking and seeing if there's a Better product.

And so then it's a question, is that worth that amount of time to be analyzing all these things rather than just have a lower allocation to stocks and rebaLance? And in that way, by doing that, we can reduce violation li drag, get IT in a level that we're counter with and don't have to analyze a complex option based product that is created because as humans, we have lots of version so that our analysis of buffer ts jury is still out there is still relatively new, but we do have five years of history, and that five years of history shows that allocating to a buffer etf reduces a return, IT reduces the risk and attends to be one for one. And so we can achieve the same strategy, but just having a lower amount stocks and complimenting IT with a low risk asset like cash.

That episode forty five. Thanks for listening. Everything I have shared with you in this ebit been for general education.

I've not considered your specific risk situation, not provided an investment advice. This is simply general education on money investing in the economy. Have a great week.