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Defined Outcome ETFs Don’t Really Have Defined Outcomes

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What You Need to Know

  • These strategies have significant promise and are worth considering as part of a portfolio, but calling them “defined outcome” is a little misleading.
  • While these options-based products have merit — either as an ETF or an annuity — they need to be described in a way that reflects the underlying risks.
  • The question isn’t really if you’re going to have tail risk, it’s the optimal way to obtain the exposure given your risk aversion, product attributes, etc.

There is an exciting new category of ETFs that use financial options to splice up the return distributions of a variety of equity indices, such as the S&P 500, using “buffers” or “floors.” One company explicitly labels these strategies as “defined outcome ETFs.” 

While I think these strategies have significant promise, and are definitely worth considering as part of a portfolio, I think calling them “defined outcome” is a little misleading.

In my opinion, an outcome is only “defined” if it is certain (or guaranteed). Just because an investor will now earn x% when the underlier returns y% (when she would have earned y% previously), does not mean the outcome is any more “defined” than it used to be. 

The downside of these products, especially those that use buffers, can be significant in some instances. For example, if the underlier returns -40%, an investor could lose 30% in a 10% buffer product. How’s that for a “defined outcome?”

In our industry, names are important. I think consumers may not necessarily understand the risks inherent in these approaches.

This is especially so when contrasting them with other products where the outcomes truly are defined (but without the explicit label), such as those that are guaranteed (e.g., an immediate annuity) or at least those where you can’t lose money (e.g., a fixed indexed annuity). (Guarantees are based on the financial strength and creditworthiness and claims-paying ability of the insurer.) 

So, while I think these options-based strategies definitely have merit either as an ETF or an annuity (i.e., a registered index-linked annuity, or RILA) — they need to be described in a way that reflects the underlying risks. Calling them “defined outcome” doesn’t do that!

Upsides & Downsides

Investors often want the impossible: infinite upside potential with no downside. While this isn’t really a realistic goal, it is possible to create financial products that “reshape” the potential return distribution of an underlying index (e.g., S&P 500) in such a way that an investor may find attractive.

One example would be a fixed indexed annuity. FIAs have some upside but no downside, assuming the product is held to term. The upside is accomplished through call options. The amount of potential upside is driven by a variety of factors, but bond yields play an important role. 

As bond yields have declined, the upside potential of FIAs has declined, which has resulted in new types of annuities being created that allow for some downside with increased upside (e.g., registered index-linked annuities, or RILAs). These approaches have recently started becoming available in ETFs as well (e.g., through Allianz and Innovator). 

These options-based strategies are definitely more complex than your typical long-only investments; however, there are common terms used to describe the potential outcomes.

The upside potential, for instance, is typically described in terms of the participation rate and the cap. The participation rate is the percentage return of the underlier (e.g., the S&P 500) you can receive (or can be credited with) over the period. 

For example, if the participation rate is 50% and the underlier returns 30%, the product owner would only be credited with half the return (which would be 15%). The cap is the maximum potential credited return. If, for instance, the cap were 10%, the product owner could not earn over 10% for the given period, even if the performance of the underlier was significantly higher.

There are two common strategies available that have relatively different risk characteristics: floors and buffers.

With floor products, the downside is limited to some stated percentage, such as 10%. For example, if the floor is 10%, apart from the insurer’s default or inability to honor its claims-paying commitments, you can’t lose more than 10% regardless of the return of the underlier (e.g., the S&P 500).

The larger the floor (e.g., 10% versus 20%) the more the potential upside. A product with a 0% floor would have the same general risk profile as an FIA and generally relatively small upside (given the small options budget).

With buffer products, some first amount of loss is effectively absorbed by the product, based on the noted buffer level, and the investor would experience any loss beyond that point. 

For example, if the buffer were 10% and the return of the underlier were -40%, the annuitant would lose 30%. If the return of the underlier is negative, but greater than the noted buffer, the return would be 0% (e.g., if the buffer is 10% and the underlier returns -5% the investor return would be 0%). The higher the buffer (e.g., 10% versus 20%) the greater the potential upside (or cap).

Defining Risk

One could potentially argue that floor products — especially those with no downside risk (i.e., a floor of 0%, which is effectively an FIA) — have a “defined outcome” since, even though the potential upside is unknown, if the floor is 0%, you can’t lose money. 

I’d be OK saying 0% floor products have a “defined outcome.” The problem is that the ETF universe of strategies is incredibly diverse and buffers are by far the most common strategy offered. Buffers, by definition, have significantly more tail risk, which I would characterize as definitely not having a “defined outcome.”

Just because an investment has tail risk doesn’t mean it’s bad. Buffers benefit from the fact that out-of-the-money put options have been relatively expensive and, by selling them (to create the buffer), it’s possible to potentially create attractive upside. Investing in equities involves exposure to tail risk.

The question isn’t really if you’re going to have tail risk (assuming you are going to own equities), it’s the optimal way to obtain the exposure given your risk aversion, product attributes, etc.


I’m a fan of buffer and floor approaches, and I think these strategies have the potential to significantly improve portfolios, either as ETFs or annuities (i.e., FIAs and/or RILAs). 

That being said, I don’t think it’s fair to say that a product where an investor can potentially lose 30% or more has a “defined outcome.” There’s a significant degree of variation in the return profiles across these strategies and a blanket term like “defined outcome” does not accurately reflect the differences. 

While I’d like to think every investor who purchases a buffer product will understand the risks of the strategy, I don’t think that’s the case. I think other words like “defensive” or “protected” do a better job describing general approaches, but I’m definitely not a marketing guy. Regardless, I’d like to see this term revisited.

David Blanchett is head of retirement research for Morningstar Investment Management LLC. Views expressed are his own and do not necessarily reflect the views of Morningstar Investment Management LLC. This blog is provided for informational purposes only and should not be construed by any person as a solicitation to effect, or attempt to effect transactions in securities or the rendering of investment advice.