Defined outcome ETFs shook up the investment landscape three years ago.
In August 2018, a then-small asset manager, Innovator ETFs, launched the first suite of “buffer ETFs,” which were designed to provide broad market exposure for a finite period of time but with downside protection in exchange for capped exposure to the upside. Innovator U.S. Equity Power Buffer ETF (PJUL), which is the largest of the three ETFs that launched on August 8, 2018, currently seeks to track the return of the S&P 500 Index up to a predetermined cap of 7.8% while buffering against the first 15% of losses over the annual outcome period by using options. Innovator ETFs also offered a version of PJUL with 9% protection and one with 30% protection to appeal to investors with different risk profiles.
Since the summer of 2018, other asset managers, including Allianz, First Trust, Pacer and TrueShares, have offered their own suites of buffered products, and Innovator ETFs has expanded its lineup to offer exposure to the performance of the MSCI EAFE and MSCI Emerging Markets indexes, among others, through Innovator International Developed Power Buffer ETF (IJAN) and Innovator Emerging Markets Power Buffer ETF (EJAN). It has also launched S&P 500 Index–focused ETFs with 12-month outcome periods each month throughout the calendar year. Innovator ETFs recently had $5.2 billion spread across 76 defined-outcome ETFs.
While there’s competition between buffer ETFs, the major differences are between ETFs and other financial instruments. Indexed annuities have been offered by insurance companies since the mid-1990s, providing a minimum guaranteed interest rate combined with an interest rate tied to a broad stock market index. The hybrid design offered protection against stock market losses but also the potential to profit from the market’s gains. Indexed annuities were designed to appeal to high-net-worth retirees who were regularly turning to certificates of deposit.
Buffer ETFs have advantages relative to index annuities, including lower costs, reduced risks and ease of use. With an index annuity, investors pay a sales commission that can range between 3.5% and 5%, often with an annual trailing fee. In contrast, PJUL and other buffer ETFs are available to advisors to purchase on most brokerage platforms for their clients without any commissions, just like any other ETF. In addition, there are no surrender charges for early withdrawal from an ETF as there are with an annuity, and investors can swap from one ETF to another based on their risk tolerance. At the same time, at the end of the annual period, while the caps for the ETFs are reset, investors can maintain ownership of the ETF’s shares indefinitely. Meanwhile, when purchasing an annuity from an insurance company, investors need to be continually aware of the credit risks of the asset manager, but this is not relevant with an ETF where what is inside the fund matters. Lastly, many investors own annuities outside of their traditional brokerage account, making it harder for an advisor to include with other assets in a fee-based model and generate savings.
While index annuities are tax-deferred products, none of the defined outcome ETFs offered by Innovator paid out any capital gains distributions in 2020. Like traditional equity and fixed income ETFs, PJUL and the firm’s other ETFs benefit from authorized participants creating and redeeming shares in a tax-efficient manner.
Advisors and ETF strategists can use buffer ETFs to attract assets from risk-conscious investors who want to participate in some of the upside of the U.S. and international equity markets while limiting the downside. We expect buffer ETF assets to continue climbing higher in 2022.
