New ETF Tools to Define Risk in an Ongoing Bull Market
This article was originally published on ETFTrends.com.
To most, investing in the stock market has meant seeking an unknown level of growth, with an uncertain level of risk, over an unknown period of time.
“That’s just the way the stock market works,” has been the consensus for decades.
Sure, you can allocate portfolio assets among stocks and bonds to match a risk tolerance based on long-term risk and returns, but to realize those long-term return parameters every year would be considered nearly impossible with traditional methods. For decades, the only way to come close is through structured notes, or certain insurance products, which had their own drawbacks (e.g., limited liquidity, higher fees, lock-up periods, early exit fees).
These matters provided the impetus for ETF visionary and Innovator Capital Management CEO Bruce Bond, who co-founded Power Shares Capital Management in 2003 with current Innovator Capital Management CIO John Southard before selling the company to Invesco in 2006. Bond and Southard purchased Innovator ETFs to eponymously innovate an ETF industry that was growing, but in need of product differentiation in order to remain competitive.
Through its suite of Innovator Defined Outcome ETFs-- Innovator S&P 500 Buffer ETF (CBOE: BJUL) , Innovator S&P 500 Power Buffer ETF (CBOE: PJUL) and Innovator S&P 500 Ultra Buffer ETF (CBOE: UJUL) , investors can obtain defined market exposures to the S&P 500, where they can upside growth potential (to a cap), but at the same time, get a level of downside protection, over a defined time period. In other words, Bond and Southard have constructed a way for investors to know their upside growth potential, downside protection level, and outcome period, all before they invest .
BJUL, PJUL and UJUL use a strategy that mimics features of structured notes and insurance products to define downside protection levels available in three formats--9% for BJUL, 15% for PJUL and 30% (from -5 to -35%) for UJUL. All three ETFs expose investors to any upside growth potential of the S&P 500 up to a certain cap and within a defined outcome period of approximately one year. At the close of the outcome period, each ETF rolls into a new set of positions, which initiates a new outcome period. The firm anticipates issuing quarterly series of each ETF—January, April, July (referenced in this article), and October (12 ETFs total).
How the Defined Outcome ETFs Came to Life
The strategy to develop the defined outcome came by happenstance. Southard purchased a fixed annuity that offered interest credits on a predetermined rate if the S&P 500 value at the end of the contract year was greater than or equal to the S&P 500 at the beginning of the year. The financial muse hit Southard, who postulated to Bond, "Hey, it's amazing we can't get something like this available in an ETF." A few months later, Bond was having breakfast with a former PowerShares colleague, Matt Kaufman--currently a principal at Milliman Financial Risk Management LLC. It turned out Kaufman had been contemplating similar notions of offering structured outcomes on the market, similar to that of the structured note or structured annuity. “With Bond and Southard’s expertise in ETF innovation and distribution, and Milliman’s quantitative and financial risk management horsepower, we felt like we were on to something,” said Kaufman.
At that point, the idea was hatched that would form the basis for Innovator's Defined Outcome ETF suite, which was unlike anything offered in the capital markets.
Construction with FLEX Options
The suite of Innovator ETFs provide investors with point-to-point exposure to the S&P 500 through a portfolio of customized exchange-traded Cboe S&P 500 FLEX® Options (FLEX Options) with varying strike prices and the same expiration date. Offering the strategy as an ETF provides investors with the transparency, liquidity and lower costs they would not realize if they tried to obtain similar outcomes offered by structured notes or structured annuities.
Furthermore, it gives investors the flexibility to seamlessly integrate the ETFs into their existing portfolios and allow financial advisors to offer the ETFs to investors who want the added insurance component built in. By utilizing the defined outcome strategies inherent in BJUL, PJUL and UJUL, it almost renders methods of using uncorrelated assets, such as bonds, emerging markets, or other hedging strategies arcane in comparison.
"We hear people talking about them (Defined Outcome ETFs) as a bond replacement," said Bond. "People are concerned about bonds--they don't want to put a lot of money into bonds right now if rates are increasing."
The Benefits of Baking Loss Buffering Into ETFs
With the loss buffering baked into the ETF, an investor is essentially getting a level of insurance on his or her portfolio without having to actively locate an uncorrelated asset to protect against the downside vis-à-vis a motorist having to purchase brakes and air bags separate from a new vehicle. This is in stark contrast to investors who are leaving themselves exposed if the markets suddenly experience a sharp decline.
"You're really naked in the market," said Bond. "You're just out there. People typically don't have any type of protection. You're just hoping the market delivers for you, but you have no way of knowing or protecting yourself if it doesn't. What this (strategy) allows you to do is not walk out there completely naked, but to have exposure to the upside to a cap, and some of that protection built in."
With a myriad of insurance products available to protect homes, vehicles and businesses, there aren't many offerings to help investors protect their portfolios--until now. The suite of Innovator Defined Outcome ETFs gives investors peace of mind regardless of whether the bulls or bears are controlling the markets.
"We basically insure our lives up," said Bond. "Everything is insured. We have life insurance, we have car insurance, we have medical insurance, and home insurance. We insure these things because we're concerned a negative event could occur that will cost us.
"But the one thing we haven't had through the ETF is the ability to protect is our portfolio--our actual assets. For many people, this is one of their most important assets."
For more information, visit www.innovatoretfs.com.
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