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Say you’re retired or soon to be. You know stocks outperform bonds over long periods, but with significant short-term volatility. Would you be interested in an investment product that allows you to participate in price gains in stocks (up to a limit), while also offering downside protection?
Wall Street has an insatiable appetite for fees and unmatched ability to spot a hot trend. In 2020, the Securities and Exchange Commission adopted a “modernized regulatory framework” for “derivatives” (like options contracts) used by mutual funds and exchange-traded funds. Financial product designers have a keen understanding of investor psychology and are experts at giving speculators and investors what they crave, whether it’s the “action” of 3X leveraged ETFs (which magnify gains and losses on an index) or the perceived safety of ETFs that promise enhanced income or the chance to chase stock returns while also protecting against declines.
According to The Wall Street Journal, the latter category was almost nonexistent four years ago (before the SEC’s new rules) but has exploded in popularity, taking in $31 billion of new investor money over the past 12 months and bringing total assets to $120 billion. Eric Balchunas, senior ETF analyst at Bloomberg Intelligence, dubbed these funds “boomer candy” and explained their attraction to risk-averse investors who “like being in the stock market but want the protection that helps you sleep at night.” To no surprise, “a good chunk of the ETF industry is in the lab trying to design more of these funds as we speak.”
In essence, investors purchase downside protection in exchange for surrendering the upside over a stated amount. We certainly understand a 60-year-old’s desire for lower volatility, but by the same token, that investor needs to understand there is no free lunch and that capping the upside comes at a significant long-term cost.
Further, in our May 3 column, “Risk and failure indispensable to your investment success,” we argued that risk is the permanent loss of capital, not price volatility because, although stock prices are driven by fear and greed over the short term and are very volatile, the value of the underlying businesses doesn’t change much from day to day. We highlighted Oaktree Co-chair Howard Marks’ memo, “The Indispensability of Risk,” where he explained the risk of not taking risk. “Because the future is inherently uncertain,” he wrote, “we usually have to choose between (a) avoiding risk and having little or no return, (b) taking a modest risk and settling for a commensurately modest return, or (c) taking on a high degree of uncertainty in pursuit of substantial gain but accepting the possibility of substantial permanent loss.”
Nick Cordola, CFA, summarized the appeal and sales pitch on ETF Trends. “By reducing volatility and max drawdowns,” he said, “these financial sweet treats seemingly make equity risk more palatable for baby boomers, helping them weather the equity market hiccups and stay invested for the long term.” Further, “by providing downside buffers, it also reduces a retiree’s portfolio withdrawal timing and horizon risk—the risk of withdrawing funds at an inopportune time which impairs their future prospects. As Mary Poppins said, ‘A spoonful of sugar helps the medicine go down.’”
Examine the “ingredients label” on one of these actual “sweet treats,” which we’ll refer to as ETF A. According to the prospectus, ETF A “seeks to provide investment results that, before taking fees and expenses into account, match the positive price return (not total return) of the SPDR S&P 500 ETF up to a cap of 9.45%, (8.76% after expenses) while protecting against 100% of the negative price return (99.31% after expenses) of the SPDR S&P 500 ETF, for the period from July 1, 2024, through June 30, 2025.”
Both the return cap and protection are based on and assume that, 1) you purchase shares on the first day of the “outcome period” (July 1, 2024) and hold for the entire period. If you purchase or sell shares during the period, your return cap and protection will be different (ETF A’s sponsor provides daily updates).
ETF A seeks to provide the “capital protected targeted outcome,” using a witch’s brew (our term) of customized “put” and “call” “flex options” (derived from future price changes of the SPDR S&P 500 ETF) it purchases from and sells to various counterparties. It’s a complex recipe and not foolproof. Indeed, ETF A warns that, in periods of extreme market volatility or during market disruption events (precisely why the owners of ETF A purchased it in the first place), ETF A’s ability to offset investor losses or provide returns up to the cap with flex options “may be impaired.”
We express no opinion on ETF A but prefer simple vs. complex recipes. Another major change from four years ago is, the yield on the one-year U.S. Treasury has gone from around 0% to 5% (risk-free). We ran a 10,000 iteration “Monte Carlo Simulation” on future one-year S&P 500 returns. A simple, do-it-yourself portfolio consisting of 70% SPDR S&P 500 ETF/30% UST outperformed ETF A nearly 75% of the time.•
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Maggie Kamman, CFP, CMA, contributed to this column. Kim and Lee are chief operating/compliance officer and director of research, respectively, for Columbus-based investment adviser Kirr Marbach & Co. They can be reached at 812-376-9444 or mickey@kirrmar.com and roger@kirrmar.com.
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