19 Jul This new ETF offers 100% downside protection for patient investors
The quickly expanding world of buffer funds now has an option for investors who want 100% downside protection. The Innovator Equity Defined Protection ETF (TJUL) was introduced on Tuesday, the latest in the firm’s defined outcome suite of funds. This one is designed to give investors full downside protection over a two-year period, in exchange for capped upside participation of roughly 16.6%. Buffer funds from Innovator and other issuers have continued to be popular with investors in 2023 even as stocks have rallied. Money market funds have seen huge inflows this year, suggesting many investors are still reluctant to to take on risky investments. “Advisors all have clients or potential clients that are too fearful to invest,” said Tim Urbanowicz, head of research and strategy at Innovator. “They can’t stomach the volatility or the short-term drawdown, and for that reason they simply just miss out. … What this strategy was designed to do is to provide an alternative for those types of clients to get cash into the market.” The fund is essentially a three-pronged options strategy, using flex options. Effectively, the strategy involves buying a call option on the SPDR S & P 500 ETF Trust (SPY) whose strike price is well below the current market level, which provides the upside participation. Then, Innovator will buy a put option that is “at the money” for downside protection, while selling a call option whose strike price is above current market levels. That second call option helps offset the price of the other two but limits the potential upside. To be sure, the fund’s total return could still be slightly negative when accounting for fees and fund costs. The Equity Defined Protection ETF has an annual expense ratio of 0.79%. Timing is key One important wrinkle to the fund is that the downside protection and upside cap are relative to when the fund was set. In other words, if the market rises 10% over the next month, an investor who buys into the fund at that point would have some potential downside and less potential upside. “With a product like this, investors really have to pay attention to what the remaining cap is. If you’re going to be capped out pretty quickly, then obviously there isn’t much incentive to get into the product,” said Aniket Ullal, head of ETF data and analytics at CFRA. “So I think there will be periods when it’s more attractive than others, depending on … the market. But I think that’s just the nature of all defined outcome products,” he added. The two-year time element is also a key consideration for investors. Because the fund holds derivatives, it will not perfectly track the SPY when the options are still far from expiration. That means that the fund won’t capture upside immediately if there is a large market rally in the next six months, for example, and investors would need to wait until mid-2025 to capture their full upside. “At the beginning, you won’t see much movement at all,” Urbanowicz said. “If the market’s up, you’re not going to see as much participation as you would with a traditional [fund] because you have that time value component attached to the options position.” He added that the two-year timeframe was needed to create meaningful upside for investors, given the market price of the options used to build the strategy. Other other securities generating safe returns will compete with TJUL. Most notably, perhaps, 2-year U.S. Treasury notes currently trade at a yield of more than 4.7%, which means investors could lock in more than half of TJUL’s potential upside over the same time frame with what is perceived as the world’s safest asset class. Tax efficiency The TJUL also doesn’t pay out dividends or coupons, which means the fund makes more sense for investors who don’t need additional cash and want to limit their taxes. “We think this is a really good way to increase upside potential overall, and I think the other thing that is probably underappreciated but is also really important is the tax treatment of these different strategies,” Urbanowicz said. Innovator offers monthly versions of its funds for other buffer products, but plans to have semi-annual versions of this latest fund, Urbanowicz said.