The rapidly expanding world of buffer funds now offers an option for investors who want 100% downside protection. The Innovator Equity Defined Protection ETF (TJUL), launched Tuesday, is the latest in the firm’s series of defined outcome funds. The scheme is designed to provide investors with full downside protection over a two-year period in exchange for an upside participation cap of approximately 16.6%. Buffer funds from Innovator and other issuers continue to be popular with investors in 2023 despite the stock market rally. Money market funds have seen massive inflows this year, suggesting many investors remain hesitant to make risky bets. “The advisor’s clients or potential clients are afraid to invest,” said Tim Urbanowicz, director of research and strategy at Innovator. “They can’t tolerate volatility or short-term drawdowns, so they just miss out… The strategy is designed to give these types of clients another option to bring cash into the market.” The fund is essentially a three-pronged options strategy, using flexible options. Effectively, the strategy involves buying call options on the SPDR S&P 500 ETF Trust (SPY) with strike prices well below current market levels, thereby providing upside participation opportunities. The innovator would then buy “at the money” puts for downside protection while selling calls with strike prices above current market levels. The second call option helps offset the price of the other two calls, but limits the potential upside. To be sure, the fund’s total return could still be slightly negative when fees and fund costs are factored in. The Equity Defined Protection ETF has an annual expense ratio of 0.79%. Timing is key An important question for this fund is that downside protection and upside caps are relative to the timing of the fund’s establishment. In other words, if the market rises 10% in the next month, investors who buy the fund at this time will face some potential downside and less potential upside. “With a product like this, investors really have to look at what is the remaining cap. If it’s going to hit the cap soon, then obviously there’s not much incentive to get into the product,” said Aniket Ullal, head of ETF data and analytics at CFRA. “So I think, in some periods, it’s going to be more attractive than others, depending on the … market. But I think that’s the nature of all definitive outcome products,” he added. The two-year time factor is also an important factor for investors to consider. Since the fund holds derivatives, it won’t track SPY perfectly when the options are far from expiration. This means that if the market rebounds sharply in the next six months, the fund will not get immediate upside and investors will need to wait until mid-2025 to get the full upside. “In the beginning, you don’t see much movement at all,” Urbanovic said. “If the market is going up, you won’t see as much participation as you would in traditional (funds) because you have a time value component attached to your options positions.” He added that it would take a two-year time frame to create meaningful upside for investors, given the market prices of the options used to formulate the strategy. Other securities that generate safe returns will compete with TJUL. Most notably, the two-year U.S. Treasury note is currently yielding over 4.7%, meaning investors can lock in more than half of the potential upside in TJUL over the same time frame, as TJUL is considered the safest asset class in the world. Tax Efficiency TJUL also doesn’t pay a dividend or coupon, which means the fund makes more sense for investors who don’t need extra cash and want to limit taxes. “We think it’s a really good way to add to the overall upside potential, and I think the other thing that’s probably underappreciated but also really important is the tax treatment of these different strategies,” Urbanowicz said. Urbanowicz said Innovator offers a monthly version of the fund for other buffers, but plans to launch a semi-annual version of the newest fund, Urbanowicz said.
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