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So I was looking through a list of all U.S. ETFs trying to look for ones that use unique and interesting strategies; one series that I found particularly interesting were the Innovator Defined Outcome ETFs. They have 3 different targets, 9%, 15% and 30% buffers, for 4 different starting months, January, April, July, October, with outcome periods resetting every year. These funds allow you to invest in the S&P 500 while buffering downside (although returns are capped). As they have multiple funds for different starting time periods, you can switch between them to lock in gains. They are launching a new series on June 3rd, and investing at launch/reset can have advantages than investing partway through.
These ETFs use 3 layers of options strategies, one in order to provide a 1:1 relationship with the SPX (SPY), another to provide a buffer (buying an ATM put, and selling a put at the buffer level, so 85% for a 15% buffer), and in order to pay for the buffer, a call is sold resulting in a cap. The liquidity of the funds is therefore tied to the S&P 500 index options market ($4.9T open interest as of March 12, 2019 according to the CBOE).
Background
A large part of America’s wealth is held by retirees and pre-retirees, who care more about managing risk than maximizing returns. Due to this there is a great demand for strategies that can mitigate downside risk.
These can include:
Modern Portfolio Theory – where a portfolio is made up of uncorrelated assets.
- This has worked historically, but asset correlations can often approach 1 during crashes.
- This has no predictability for the future. It might have worked well in the past, but if all asset classes become more correlated in the future, it won’t provide any protection.
Bonds – The classic low risk income investment.
- Rates are still historically on the low side, and might not be able to provide as much protection or income as it did in the past.
- If you’re concerned about inflation, (non-floating rate) bonds won’t offer much protection.
Asset Rotation/Market Timing – can include things like “sell in May and go away”, computer models, seasonal rotation (Horizon’s Seasonal Rotation ETF, TSE:HAC is a good example), or be left to the discretion of the investment manager/advisor. This is based on the past, manager skill and whether the ability to market time exists (which, if you believe that the market is efficient all the time isn’t possible)
Hedge Funds
Hedge funds can come with very high fees, and often fail on performance compared to the S&P 500.
- See Eli’s article about this. If you want to beat market returns and reduce risk compared to indexes, it might be better to follow his advice at the bottom of his article “DIY investors looking for an edge (shameless plug) should obviously be using Seeking Alpha every day, and may want to take a look at some of the (IMHO) remarkable private forums in our Marketplace, or SA PRO which gives you exclusive access to some of our authors’ best long and short ideas.”
- Louis Kokernak also shows how hedge funds have done worse than even a 60/40 balanced portfolio in absolute returns and risk adjusted returns.
To invest in hedge funds, you’d have to be an accredited investor (which most people are not). They may also have high minimums, be illiquid and may lock up your assets.
Even though hedge funds failed to increase risk/adjusted returns, investors are still hungry for anything that can potentially have lower risk or higher risk-adjusted returns. There is $3.2T managed by hedge funds.
Short Selling
- Can increase risk and reduce returns if short bets are wrong.
- Upside is limited.
- It would require market timing to be most effective.
Structured Notes/Annuities
- This does work, but there’s a lot of disadvantages: high fees, commissions, illiquidity, not transparent, and credit risk.
- There is $1T in equity-linked structured products (according to Innovator)
The advantages of these ETFs are that is not a note, meaning actual options are owned by the fund rather than using swaps. As options are used there is very little credit risk (only that involved with options with the Options Clearing Corporation). Holdings are very transparent generally in ETFs, and it comes with all the liquidity of ETFs. However, do not buy it if you don’t understand how it works (this should apply to stocks too); if you’re considering investing in these funds please consult a qualified financial professional. The strategy can be a bit confusing initially, but it’s actually a pretty innovative strategy that Innovator has developed. The funds have an expense ratio of 0.79%, which is high for ETFs, but much lower than hedge funds or structured products and has more certainty than Modern Portfolio Theory portfolios or short selling.
The ETFs
There are currently 4 starting months for the each buffer group of ETFs, October, July, January, and April.
January Series | Ticker | Initial Buffer / Remaining Current Buffer | Initial Cap / Remaining Cap |
INNOVATOR S&P 500 BUFFER ETF- JAN | BJAN | 9% / 10.32% | 22.3%/ 12.41% |
INNOVATOR S&P 500 POWER BUFFER ETF- JAN | PJAN | 15% /18.91% | 13.9%/ 6.60% |
INNOVATOR S&P 500 Ultra BUFFER ETF – JAN | UJAN | 30% (5-35%) /35.27% | 12.0%/ 6.06% |
April Series | |||
INNOVATOR S&P 500 BUFFER ETF- APRIL | BAPR | 9% / 8.02% | 17.24% / 17.8% |
INNOVATOR S&P 500 POWER BUFFER ETF- APRIL | PAPR | 15% / 13.49% | 10.61% / 10.69% |
INNOVATOR S&P 500 Ultra BUFFER ETF – APRIL | UAPR | 30% (5-35%) / 28.53% | 10.57% / 10.71% |
July Series | |||
INNOVATOR S&P 500 BUFFER ETF- July | BJUL | 9% /6.00% | 10.85% / 11.60% |
INNOVATOR S&P 500 POWER BUFFER ETF – July | PJUL | 15% / 12.47% | 8.11% / 7.31% |
INNOVATOR S&P 500 Ultra BUFFER ETF – July | UJUL | 30% (5-35%) / 29.68% | 8.77% / 9.09% |
October Series | |||
INNOVATOR S&P 500 BUFFER ETF – Oct | BOCT | 9% /6.44% | 15.3% / 17.03% |
INNOVATOR S&P 500 POWER BUFFER ETF – Oct | POCT | 15% / 11.51% | 10% / 10.80% |
INNOVATOR S&P 500 Ultra BUFFER ETF – Oct | UOCT | 30% (5-35%) / 27.71% | 9.99% / 11.99% |
Data is from the pages of each ETF on Innovator’s website.
Each cap is set at the beginning of each 12-month period based on options prices upon launch/reset. The buffer / cap profile would end up being different for someone who invested at inception/reset than someone investing partway depending on S&P 500 price returns – therefore affecting your potential risk/returns. For example, let’s say the ETF’s cap was 15% with a 9% buffer and the ETF had returns of 14% so far, this essentially means that your returns would be limited to 1%; there’d also be a greater distance to where the buffer starts, although the remaining buffer might be greater if the fund underperformed SPX earlier in the outcome period (remaining buffer = starting buffer – (fund return – SPX return)).
If you invest after the fund experienced negative returns, but still within the buffer zone, then the distance from the cap is greater, although the buffer size would be smaller; if the SPX finishes the year anywhere in the buffer, then expected return of the fund would be zero, meaning you’ll get the difference between how much in the buffer it was and zero. So let’s say you bought the 15% buffer ETF when the fund was down 10%, and the SPX finished the year at -15%, then you would have a gain of about 11%.
If you purchase after the fund experiences greater negative returns than the buffer then it will offer no buffer protection.
If SPX has greater losses than the buffer (9% for the B-series ETFs, 15% for the P-series ETFs, and 35% for the U-series ETFs), then the fund will incur losses on a 1:1 ratio after the buffer.
You should check what the target buffer/caps as well as the remaining buffer/caps are on their website and weekly rate sheet before investing. The remaining cap/buffer which is italicized in my table above, allows you to see what the cap/buffer would be for someone just purchasing the fund now rather than at launch/reset.
June Series Funds
If this sounds like a strategy for you, they are launching an ETF on June 3rd with an outcome period ending in a year. By investing at launch rather than partway through the outcome period, you can make sure that your cap/buffer profile is as described in the target and most advantageous.
The funds for June are BJUN, providing a 9% buffer, PJUN for a 15% buffer and UJUN for 35% buffer.
BJUN would likely have a cap of 10.85%, PJUN would likely have a cap of 8.81%, and UJUN would likely have a cap of 8.77% (according to their not yet public webpages).
Payout Profiles
Here are the target payout profiles for these ETFs.
Please note they are “for illustrative purposes only” and describe the outcome for an investor starting at launch/reset and holding until the end of the outcome period (a year). Note that fees aren’t included.
9%-Target Buffer ETF
You will be insulated for the first 9% loss (at the end of the outcome period), meaning for a loss greater than that, you’d only lose the difference between that and 9%. So let’s say “aliens invade and Earth gets nuked”, but somehow the options market is left standing, then you’d only lose 91% instead of 100%.
15%-Target Power Buffer ETF
Any losses less than 15% at the end of the outcome period would result in a gross return of zero. Note this does not include fees.
30% Ultra Buffer ETF
This exposes you to the first 5% of downside, but buffers for the next 30%, meaning a 35% drawdown of the SPX should only result in a 5% decline for this fund at the end of the outcome period. If you believe that it is more likely that the market will crash within the year, but you’re not 100% sure and still want a bit of upside, this is probably the fund for you.
Source: Innovator’s payout profiles document
How do these buffers work?
Source: Innovators Webinar
Layer 1: Long Position
Table: Option positions held on SPX in order to provide 1-to-1 S&P 500 exposure
Direction | Type | Moneyness | Quantity |
Long | Call | 60% | 2 |
Short | Put | 60% | 2 |
Long | Put | 120% | 1 |
Short | Call | 120% | 1 |
This options strategy allows the fund to track the S&P 500 with a 1:1 ratio by the end of the outcome period (when options expire or are exercised and new ones are bought). It might not track the S&P 500 perfectly, especially earlier in the outcome year due to variations in option pricing, but by the time the options expire, any gaps between the SPX and the fund’s performance during that time period should disappear (on a gross basis, before fees).
In order to test this, I used Optionistics’ profit calculator, and as you can see forms a relationship where every $1 increase leads to a gain of about $100 (as an options contract on stocks usually covers 100 shares), with the break even point being the about same as the current price (data as of May 9).
Source: Optionistics
Layer 2: The Buffer
Direction | Type | Moneyness | Quantity |
Long | Put | 100% | 1 |
Short | Put | 85% (for a 15% buffer) | 1 |
The put option bought should insulate you if the S&P 500 goes below its starting value, the strike price is at a 100% level of the starting value for the 9% and 15% buffers, and at 95% for the 35% buffer. The 9% buffer would write a put at 91% rather than 85%, and the 35% buffer would write a put at 60% (95% – 35%).
This net proceeds from this layer is going to be negative, meaning this layer costs money rather than generating money from premiums. This is because option prices are more expensive when the strike price is closer to the current price, therefore the option that is bought at 100% is more expensive than the option sold at 85%. This layer also shifts the profit/loss curve downwards when it expires. Whereas layer 1, in the simulation, broke even at the end of the term/expiration where the current start price is, this layer requires the stock price to go up by ~$12 or about 4.3% (the difference in the price between them) to break even.
Here’s the trades I put in. Note that for this simulation, the current stock price is $279.05 (current price) whereas with the previous simulation, the price was as of May 8.
Source: OptionsProfitCalculator
Layer 3: The Cap
Doesn’t everyone wish you could buffer your losses, track returns one-to-one without any caps to gains? The cap is created using a call option. The reason this needs to exist is to finance the purchase of the put options, so that a 0% gain in the SPX matches up with a 0% gain rather than a loss (as caused by the cost difference between the 2 put options). The reason why the cap is different for each outcome period is that it is set dynamically in order to reflect the price difference between the 2 puts in the buffer (with option pricing being dependent on interest rates, and volatility, among other factors).
The price difference between the 2 puts was about $12 ($11.87). Therefore, the call should be at whatever strike price is closer to $12. Looking at the current pricing chart, it looks like the appropriate strike price would be between $290 and $295. Since $290 is the closest to the price difference between the 2 puts I’m going to select that one. A $5 difference is about 1.8%, which means by choosing that $290 option, it’s going to result in a about 1% lower cap than if an option between $290 and $295 existed. The ETF uses FLEX options in order to avoid this – that way they can customize the price in order to avoid having to round and losing efficiency.
Source: OptionsProfitCalculator
I made a manual entry at $292 with an $11.87 strike price. The goal is to make a 0% return on the S&P 500 result in a $0 return, if $290 was used it would mean that a 0% return results in a profit of about $100 ($1 x 100, or 0.35%) since its price is $1 more than the puts price differential. If the $295 strike price was chosen, its price would be $1.45 less than the puts price differential, meaning a 0% return would result in a $145 ($1 x $100) loss, or about -0.5%.
Source: OptionsProfitCalculator
Note: The options calculator has a limit of 6 options/strategy, meaning that the cap would not fit, therefore I substituted layer 1 (S&P 500 exposure) with a simpler 2 option synthetic long (by buying a call ATM and selling a put ATM).
Here’s the detailed options breakdown:
So with the profit/loss graph above, a 0 % change in the S&P 500 should result in a $0 profit. Anywhere that finishes on the buffer is limited to zero. As you can see the profit/loss does not really act as a buffer at the beginning of the period, but as time approaches expiration the curve starts looking more like a 1:1 relationship with a buffer from 0 to -15% in the middle.
What if you buy the fund mid-time period?
Here’s how returns would look like with a buffer (with options expiring on June 20, 2020). This is the graph from “Layer 2: The Buffer” earlier and would be a slightly more accurate representation than the Layer 3 one, as the Layer 1 options had to be substituted to make room for the Layer 3 call (since there was a limit of 6 options/strategy in the calculator I used). The Layer 3 call had the purpose of financing the put options in Layer 2, adding in the cap, and shifting the graph upwards, so let’s assume that the thick horizontal blue buffer section of the graph (in the middle of where it otherwise results in a 1:1 relationship) lines up with zero since that’s one of the 2 things the calls sold does.
The previous graph is based on options purchased now but expiring on June 20, 2020, so let’s invent a hypothetical version of the fund with a weird outcome period of a year and 3 weeks. So from the graph below, let’s say you purchased where the red dot is (looks like this August), or about a price of $235 (the end of the buffer). If you just held on to the ETF from that date until the expiring date of June 20, 2020, and SPX stays constant from then you would have a profit of the difference from the red dot to the green dot (see marked chart below, right at the end of the buffer).
Source: Myself based on OptionsProfitsCalculator chart.
Notice that the buffer is effectively lengthened to the price where the yellow dot is (~$215)?
Buffer remaining = initial buffer – (gains of fund – gains of S&P 500).
So the initial buffer was 15%, let’s just say that the returns of the fund and SPX are both equally negative, then the buffer for a person investing even after the start would still be 15%. Let’s say that the fund avoided a bit of the losses, with the SPX having a loss of 15% compared to let’s say a loss of 12% for the fund. Then the remaining buffer = 15% – (-12% – -15%) = 13%.
What if you buy after the S&P 500’s had positive returns?
Here’s an example for UJAN. The cap for the outcome period was 12.00%, however, since the fund won’t perfectly track the S&P 500 during the first half, it should still converge together at the end of the outcome period. So even though the S&P 500 basically reached its cap, if you just bought now, the remaining cap would be ~6% still. However, this would affect downside risk, as there would be a greater distance to where the buffer starts than when it just started (at zero), so it would probably be better to roll over to another timeframe when it resets.
Source: ETF’s website
Trade Idea: Locking in Rallies
At the end of March, the S&P 500 was up 13%. An investor who invested in the S&P 500 could have decided to purchase one of the April series funds to lock in those gains, and provide a buffer against downside risk, while still maintaining some exposure to the market (especially if you believe that gains greater than the caps are unlikely).
Source: Innovator ETFs Webinar
If you bought the January 9% Buffer ETF (BJAN) instead of an S&P 500 index fund, it would have captured 80% of the upside in the first 3 months, so you could reset both your caps and your buffer by switching to the April series buffer ETFs, being effectively a win-win situation.
Are High Returns Likely?
This one’s pretty self explanatory from the slide below (source: Innovators webinar). It’s probably more likely that returns would be less than 10%, and you can protect yourself from potential market losses by buffering them with their funds.
You can also decide instead of rolling over to the ETF at the start of the term, to instead invest partway through, especially if you believe the market will temporarily go down before the end of the outcome period. See below for an example:
Risks/Downsides:
- Can be hard to understand.
- If the Options Clearing Corporation were to become insolvent, then that could cause substantial losses for the fund (and all of Wall Street) as all of its assets are tied up in options.
- Options pricing means that the fund’s performance may not match up with the S&P 500’s, especially near the start of the outcome periods.
- The expense ratio is 0.79%, this is definitely high for ETFs, but it’s definitely lower than hedge funds or structured notes. It would be up to you if this is worth it.
So I’d like to end this with a few questions for my readers: Where do you believe the S&P 500 would in a year? What would you say the probability of a stock market (not negative GDP necessarily) loss in the next year is? Do you have any better risk avoidance schemes, or did you think you’ve had one in the past where it instead failed?
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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