By Keith Whitcomb, RMA
One year, my son’s baseball team played in the league championship game. Everything was going great until the star pitcher tired out a few innings too early. Lacking a viable alternative, the coach was forced to bring in the “closer.” He was a big kid who could throw hard, but not for very long. After one good inning, he got wild and the other team went on to win. It illustrated how in baseball it can be difficult to find good pitching in between the starter and the closer. Those middle innings…
In a similar way, it can be challenging figuring out how to invest in those middle rungs of a laddered retirement income investment strategy. Assets in year one or two are likely located in high-quality cash or near-cash equivalents. On the other end of the ladder, you can get more aggressive and invest in equities. But what about the three to six years in between?
Traditionally a portfolio of “safe” bonds would work, potentially even matched to meet future liabilities. However, given today’s low interest rate environment and building inflationary pressures, there is little return and significant risk in bonds.
Defined Outcome ETFs
Strategies that guard against financial market downturns by selling off the potential for asset appreciation have been around for years. For retail investors, variable annuity products sold by insurance companies have conveniently packaged this protection. Unfortunately, low liquidity, high fees, large account minimums, and complexity have made these solutions a poor fit for many.
Enter the Defined Outcome Exchange Traded Fund. By shaping the risk/return profile of your assets to match the timing and nature of your budgeted cash flows, this product brings together desirable risk management properties in an ETF wrapper that eliminates many of the shortcomings of variable annuities. It may be a good fit for the rungs of a laddered portfolio strategy that fall between short-term stable/liquidity-focused and long-term appreciation-oriented investments. For example, you could use a large buffer for near-term non-discretionary rungs, and a smaller buffer for longer-term discretionary needs. Here’s some additional information:
Product Details – Innovative Capital Management first launched this ETF in August of 2018 and shares a leading role in this space with First Trust/CBOE Vest. Typical product features include: daily liquidity, a twelve-month protection time frame, automatic rollover and reset of cap and buffer, a range of upside/downside coverage alternatives, and a choice of reference indexes including SPY, QQQ, EFA, and the Russel 2000. New structures are sold at the beginning of each month, enabling you to spread your purchases out over the entire year. This can eliminate being exposed to a single annual reset date.
Protection – With this product, investment gains are capped at a defined maximum percentage. In contrast, losses are minimized with a softer “buffer.” The buffer provides a layer of protection, but negative returns outside of a specified range of coverage will be yours to keep. Since the cost of protection is paid for by selling off your opportunity for asset appreciation, the more potential upside you give up, the more downside protection you get. Here is a table of April 2021 cap/buffer terms that uses the S&P 500 as a reference asset.
Price - Expense ratios for these ETFs are in the .80% neighborhood (plus possible brokerage commissions, trading fees, taxes and extraordinary expenses) which seems high for an ETF. However, when compared to insurance products with similar risk mitigation features that are priced at 1.25% for management and subject to other fees (like contract maintenance charges, withdrawal charges, premium taxes, and investment fund operating expenses), the cost looks more reasonable.
Performance Characteristics – One of the first things you will notice with this ETF is that it does not track the reference asset during the twelve-month outcome period, but does reach its structured valuation at the conclusion of that time frame. This is partly due to the price behavior of the options that are used to construct the product. The takeaway here is that while you have the flexibility to buy and sell daily, it may not be financially advantageous to do so. In addition, reference assets for these ETFs are typically price appreciation only, which means dividend income is not included. However, the goal here is to enhance risk management and participate in the potential for better returns over bonds, not beat low-cost total return equity ETFs. To get a feel for intra-year pricing behavior, check out this online tool.
Let’s face it, if you are in accumulation mode and have decades before you need to tap your portfolio for cash, capping upside potential may be unnecessary and could end up stunting your account’s growth. But for individuals with an intermediate-term investment time horizon, like saving for college or for the down payment on a home, having the ability to control equity returns can be useful. The Defined Outcome ETF is perhaps most interesting for projected cash flow needs in retirement. The prospect of investing in low-returning bonds that have no downside protection, or risk-managed insurance products with high fees and restrictions makes this ETF an intriguing alternative.
What next? Try one on for size. Consider starting with a small position, maybe with some excess cash laying around in your brokerage account or IRA. Also, think about making this purchase at the beginning of the month. This will avoid any hedge profile modifications that occur after the ETF hits the marketplace. From there, you can get a feel for how it performs. Who knows, this ETF might provide you with “middle inning” relief!
About the author: Keith Whitcomb, RMA®
Keith Whitcomb, MBA, RMA®, is the director of analytics at PERKY and has more than 20 years of institutional investment experience. He is Series 6, 63, and 65 licensed.
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