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.