Defined outcome etfs

What Is Defined Outcome ETFs?

Defined outcome exchange-traded funds (ETFs) are a class of investment products designed to offer investors predetermined levels of downside protection and upside participation in a specific underlying asset, typically a market index, over a set period. These innovative financial instruments, also known as buffer ETFs, belong to the broader category of investment strategies within modern portfolio management. They aim to provide a more predictable range of potential returns by utilizing a sophisticated structure, primarily involving options contracts. Unlike traditional ETFs that seek to replicate the performance of an index directly, defined outcome ETFs intentionally deviate to offer a "buffer" against a portion of potential losses while imposing a "cap" on potential gains. This unique structure appeals to investors seeking to manage volatility and reduce risk exposure in their portfolios.

History and Origin

The concept behind defined outcome ETFs is rooted in more complex financial instruments like annuities and structured products, which also aim to provide specific payoff profiles. The first defined outcome ETFs were launched in August 2018 by Innovator ETFs, marking a significant evolution in the accessibility of structured investment strategies within the transparent and liquid wrapper of an exchange-traded fund.⁹ This introduction provided a more straightforward and liquid alternative to traditionally less accessible or more opaque products, allowing retail investors to participate in strategies previously reserved for institutional investors. Since their inception, defined outcome ETFs have seen considerable growth in assets under management, especially during periods of market uncertainty, as investors sought tools for capital preservation.⁸

Key Takeaways

• Defined outcome ETFs aim to limit potential losses over a specific period, often called an "outcome period."
• This downside protection comes at the cost of capping potential upside gains over the same period.
• These funds typically achieve their defined outcomes by using a series of derivatives, such as call options and put options, on an underlying index.
• To fully realize the stated buffer and cap, investors generally need to purchase shares at the start of the outcome period and hold them until the period's conclusion.
• Defined outcome ETFs generally have higher expense ratios compared to passively managed index ETFs due to the active management of their options strategies.

Interpreting Defined Outcome ETFs

Interpreting defined outcome ETFs involves understanding their two core components: the buffer and the cap. The "buffer" specifies the percentage of losses an investor is protected against from the underlying asset's decline over the outcome period. For instance, a 10% buffer means the fund aims to absorb the first 10% of losses. If the underlying asset falls by more than the buffer, the investor bears losses beyond that threshold.

Conversely, the "cap" defines the maximum percentage gain an investor can achieve over the same outcome period. If the underlying asset's return exceeds this cap, the investor's return will be limited to the cap. This trade-off between limited downside and capped upside is fundamental to the structure of defined outcome ETFs. Investors must also be aware of the "outcome period," which is the specific timeframe (e.g., one year, three months) over which the stated buffer and cap are effective. Buying or selling outside this period can result in returns that differ significantly from the defined outcome.⁷ The effectiveness of these funds hinges on holding them for the entire stated outcome period.

Hypothetical Example

Consider an investor purchasing a defined outcome ETF that tracks the S&P 500 Index with a one-year outcome period, a 10% buffer against losses, and a 12% upside cap. The investor buys 100 shares at $100 per share, for a total investment of $10,000, at the start of the outcome period.

• Scenario 1: Market Decline
  If the S&P 500 Index declines by 8% over the year, the investor's loss is fully absorbed by the 10% buffer. The investment value remains approximately $10,000 (excluding fees), rather than falling to $9,200.
  If the S&P 500 Index declines by 15% over the year, the first 10% is buffered. The investor absorbs the remaining 5% loss. The investment value would be approximately $9,500 (excluding fees), representing a 5% loss rather than a 15% loss.

• Scenario 2: Market Gain
  If the S&P 500 Index gains 8% over the year, the investor participates fully in this gain, and the investment value rises to approximately $10,800.
  If the S&P 500 Index gains 20% over the year, the investor's gain is limited to the 12% cap. The investment value would rise to approximately $11,200, rather than $12,000.

This example illustrates how defined outcome ETFs provide a bounded range of returns, reducing tail risk on the downside but forfeiting unlimited upside potential. This characteristic makes them a tool for risk management within a broader asset allocation strategy.

Practical Applications

Defined outcome ETFs can serve various purposes in portfolio construction for investors seeking a more controlled exposure to equity markets. One primary application is for investors nearing retirement or those with a lower risk tolerance who wish to maintain some equity exposure without the full downside risk. These funds can act as a partial replacement for traditional equity holdings, offering a blend of growth potential and downside protection.

Financial advisors may also use defined outcome ETFs to provide clients with a conservative alternative to direct market exposure during periods of high market volatility or economic uncertainty. They can be integrated into a portfolio to help achieve portfolio diversification by introducing a distinct risk-return profile that differs from traditional stocks or bonds. Additionally, these ETFs can simplify the process of implementing complex options-based strategies, making them accessible to a wider range of investors without requiring direct involvement in options trading. All financial products, including these ETFs, are subject to regulatory oversight regarding their marketing and disclosures, ensuring investors receive clear and accurate information.⁵, ⁶

Limitations and Criticisms

Despite their appeal, defined outcome ETFs have several limitations and criticisms that investors should consider. A significant drawback is the trade-off inherent in their design: the upside potential is capped in exchange for downside protection. This means investors will miss out on larger gains during strong bull markets.⁴

Another important consideration is the impact of the expense ratio, which is typically higher for defined outcome ETFs compared to passive index funds due to the active management of their options strategies. These fees can erode a portion of the returns, particularly when upside is capped.³ Furthermore, investors in most defined outcome ETFs do not receive dividends from the underlying stocks. For an index like the S&P 500, dividends can contribute a meaningful portion of total returns over time, which is foregone in many of these structures.

The effectiveness of the buffer and cap is largely dependent on holding the ETF for its entire predetermined outcome period. Investors who buy or sell shares outside this specific timeframe may experience outcomes that differ significantly from the stated objectives, potentially losing the intended protection or upside participation.² Critics also point out that while these funds offer a defined outcome, they are still subject to market risks, and the buffer is not a guarantee against all losses; investors bear any losses exceeding the buffer level.¹

Defined Outcome ETFs vs. Structured Products

Defined outcome ETFs and structured products share a fundamental goal: to provide investors with a predefined risk and return profile based on the performance of an underlying asset. Both typically use derivatives, such as options, to achieve their specific outcomes, offering a degree of capital protection or enhanced returns in exchange for certain limitations.

However, the key differences lie primarily in their accessibility, liquidity, and regulatory frameworks. Structured products are often custom-tailored, privately negotiated investments issued by banks or financial institutions. They can be complex, less transparent, and generally lack secondary market liquidity, meaning they are difficult to sell before maturity without incurring significant penalties. They are also typically sold to a more sophisticated investor base and can carry issuer credit risk.

In contrast, defined outcome ETFs are exchange-traded funds, offering greater liquidity as they can be bought and sold on major stock exchanges throughout the trading day, similar to individual stocks. They benefit from the transparency and regulatory oversight associated with the ETF wrapper, including daily disclosure of holdings. While the underlying strategy might be complex, the investment vehicle itself is designed for broader accessibility, making the defined outcome strategy available to a wider range of investors.

FAQs

How does a defined outcome ETF provide downside protection?

A defined outcome ETF typically achieves downside protection by using a combination of options contracts, such as buying put options on the underlying index. The premium paid for these put options is often offset by selling call options, which caps the potential upside but helps finance the downside buffer.

What is an "outcome period" in a defined outcome ETF?

The outcome period is a specific, predetermined length of time (e.g., one year, six months) during which the defined outcome ETF aims to provide its stated buffer and cap. To fully realize these features, investors are generally advised to hold the fund for the entire duration of this period, from its commencement to its expiration.

Are defined outcome ETFs suitable for all investors?

No, defined outcome ETFs are not suitable for all investors. They may be a consideration for those seeking a balance between equity market participation and downside protection, particularly conservative investors or those nearing retirement who want to manage risk without fully exiting the market. However, investors comfortable with higher risk and seeking uncapped growth potential, or those with very short-term investment horizons, might find these funds less appealing due to their capped upside and specific holding period requirements.

Do defined outcome ETFs pay dividends?

Most defined outcome ETFs generally do not pay dividends from the underlying stocks they track. Their structure, which typically uses options contracts rather than holding the underlying equities directly, means that dividend income is usually not passed through to shareholders. Investors should review the specific fund's prospectus for details on its dividend policy.

Can I lose more than the stated buffer in a defined outcome ETF?

Yes, you can lose more than the stated buffer. The buffer protects against a specific percentage of losses. If the underlying asset's decline exceeds that percentage during the outcome period, you will bear the losses beyond the buffer. For example, if a fund has a 10% buffer and the market falls by 15%, you would experience a 5% loss.