Options-based ETFs offer equity cushion without using bonds – Citywire USA

John Coumarianos

The Innovator Buffer funds deliver the modified equity exposure of index annuities with liquidity, more transparency, and lower fees.

The traditional way to de-risk a portfolio is to reduce stock exposure and add bond exposure. Most of the time, that will cut longer term returns but also reduce downside volatility.

Muting declines can help prevent investors from selling stocks at market bottoms, and realize the full benefit of whatever stock exposure they have. It can also benefit retirees withdrawing from their nest eggs because sizable declines in the early years of distribution can be catastrophic for portfolios.

The trouble is that today, most investment-grade bonds offer such paltry yields that they look likely lock in inflation-adjusted losses for investors. And for better or worse, that’s making it harder to justify using them as portfolio shock absorbers.

Enter options-based funds that gain exposure to stocks while limiting both downside and upside. This is the strategy that has undergirded index annuities for years, but now investors can have it in a lower-cost mutual fund or ETF.

While Morningstar’s Options-Based fund category is a pipsqueak at $62bn, one fund — the now-closed $19bn JPMorgan Hedged Equity fund (JHQRX) managed by Hamilton Reiner and Raffaele Zingone — has 30% of the category’s assets. JPMorgan has three other funds as well: JPMorgan Equity Premium Income ETF (JEPI), JPMorgan Equity Premium Income (JEPRX), and JPMorgan International Hedged Equity (JIHRX).

JPMorgan closed Hedged Equity in March when it was 40% of the category.

The other group of funds taking up a decent chunk of the category is the Innovator funds founded by Bruce Bond and John Southard. Innovator is Bond’s and Southard’s second foray into the ETF business. They founded PowerShares in 2002, and the duo sold the firm to Invesco in 2006.

Innovator has grown its assets by more than tenfold in three years, from half a billion dollars in late 2018 to around $5.8bn, according to data from Morningstar. Over the last one-year period through October, it has taken in $1.3bn, putting it in the top 5% of fund families for inflows.

The JPMorgan and Innovator funds have broad market exposure, while using put-spread-based options strategies to limit both upside and downside.

A ‘put-spread collar’ involves buying an out-of-the-money put option and simultaneously selling a further out-of-the-money put option to obtain the desired protection against loss. In order to finance the cost of the put spread, the second part of the strategy involves selling an at- or near-the-money call option, which limits potential gains.

All of this allows investors to choose the amount of downside protection they want, and the Innovator funds that deliver this capped exposure to the S&P 500 come in three flavors – plain ‘Buffer’ funds, ‘Power Buffer’ funds, and ‘Ultra Buffer’ funds, protecting against the first 9%, 15%, and 30% of losses. The Ultra Buffer funds deliver the first 5% of losses to the investor and provide protection for the next 30% of downside.

Because the Innovator funds use options strategies, their downside protection and upside potential can vary. So the firm has issued funds in each category – plain Buffer, Power Buffer, and Ultra Buffer – for each month of the year. The firm’s website lists each fund’s remaining cap and buffer.

The idea is for an initial investment to correspond to the current month. But once the investment is made, if it’s intended to be a long-term position, there isn’t a need to roll into the next month’s fund.

We looked at how the funds performed during last March’s Covid swoon (Feb. 20, 2020 – March 23, 2020), listing the best, the worst, and the average, in the table below. The S&P 500 lost 33.79% during this period and the Vanguard Balanced Index (VBINX) fund lost 22.78%.

Name Return, Feb. 20, 2020 – March 23, 2020 Return, 2020 Fund Size ($m)
Innovator US Equity Buffer ETF, BJUN -23.14 9.94 79.40
Innovator US Equity Buffer ETF™ Feb, BFEB -25.61   78.00
Buffer average -24.8 11.22  
Innovator US Equity Power Bffr ETF Apr New, PAPR -15.86 4.58 207.30
Innovator US Equity Power Buffer ETF Jan, PJAN -20.03 7.73 275.10
Power Buffer average -17.69 8.31  
Innovator S&P 500 Ultra Buffer ETF™ Feb, UFEB -13.32   25.90
Innovator S&P 500 Ultra Buffer ETF – Aug, UAUG -14.45 7.48 34.10
Ultra Buffer average -13.75 5.60  
S&P 500 TR -33.79 18.4  
Vanguard Balanced Index, VBINX -22.78 16.26  

 Source: MorningstarDirect

All the plain Buffer funds lost between 23.1% and 26.3% during the Covid swoon. The Power Buffer funds that existed lost between 15.9% and 20.0%, showing the greatest disparity. Finally, the Ultra Buffer funds lost between 13.3% and 14.5% during the period.

The Ultra Buffer performance may have seemed surprising since those funds are supposed to protect between -5% and -35%. But the options-based buffer works over the full outcome period, not necessarily providing the full 30 percentage points of protection over a one-month period. Though the Defined Outcome ETFs did cushion the market drawdown relative to the S&P 500, investors must hold the ETFs for the entirety of the outcome period to fully benefit from the buffer mechanism.

For the year, when the S&P 500 returned 18.4% in a remarkable turnaround and the Vanguard Balanced Index fund delivered 16.3%, the plain Buffer funds delivered between 9.9% and 14.5%. The Power Buffer funds delivered between 4.6% and 10.4%, while the Ultra Buffer funds returned between -5.1% and 7.6%.

The Buffer funds acquitted themselves well during the Covid swoon, but less well versus the Vanguard Balanced Index fund for the year of 2020 — though their high-single-digit returns still qualify as equity-like. But that’s to be expected in an unusual year when the return of the balanced index (16.3%), owing to its small cap exposure (it tracks the MSCI USA index for its equity exposure) and its bond exposure, helped it nearly match the return of the S&P 500 (18.4%). Over the course of a full market cycle, which the Buffer funds haven’t yet seen, the comparison to the balanced index may look more favorable.