(MarketWatch) You’ve heard of defined-contribution and defined-benefit retirement plans. Get ready for defined-outcome investing.
The “outcomes” that these plans claim to define have some limits: they can’t predict the winning lottery number, get your child into college, or ensure you hit only green lights on your commute home. But in a world of head-spinning financial market volatility, their promise – of a buffer against the downside, in exchange for a ceiling on the upside of your returns – may be just as good.
“Defined Outcome” is the name of an exchange-traded fund strategy and the products that use it, from a company called Innovator ETFs. The Innovator team wanted to meld the investor-friendly set-up of ETFs with a financial management concept that sounds good but often falls short: annuities.
Workers near retirement – or any other life milestone that may require more certainty – are especially vulnerable in times of big market churn. There’s some stability – though little yield – in fixed-income, pointed out Graham Day, Innovators’ product head. And research consistently shows that most investors would do best to remain invested in a broad basket of stocks.
The Defined Outcome funds use options, which are bets that stocks will go up or down to limit big swings in values. Investors’ potential gains are capped, but potential losses are also limited. Buffers of 9%, 15%, or 30% are available.
What does that mean in practice?
An investor buying into the Defined Outcome “Power Buffer” ETF – that is, the offering with a buffer of 15% – can expect that if the market is down, say, 18% over the 12-month period in which the fund is active, he will only lose 3%. Defined Outcome funds started as quarterly offerings and are now issued every month for a 12-month life span. In other words, an investor buying into the June today will only receive the benefit of the cap over the next 10 months.
“We’re not believers in market timing,” Day told MarketWatch. “We don’t believe you can say, buy equities now.” He stresses that the funds are “not trading vehicles.” But for sophisticated investors or advisers with particular time constraints, there can be value in buying into one of these products nearer the end of its life than its beginning. That allows the benefits of exposure to a broad basket of stocks – in this case the S&P 500 or one of two indexes from MSCI – while limiting the amount of possible downside.
Innovators publishes a grid that shows remaining time periods and caps for each of the products on its web site, updated throughout the day.
A “significant” amount of money has chased after ETF products offering protection against market downsides, said Todd Rosenbluth, director of mutual and exchange-traded fund research at CFRA. “Investors and advisors want to be exposed to the equity market but in a more risk-controlled way,” he said.
Market choppiness over the past year, from December’s massive sell-off through the roller coaster ride of early August, has helped make the case for the Defined Outcome funds, Rosenbluth observed. “We now have a year’s worth of proof to be able to see here’s what happened, here’s what it delivered. Pockets of volatility have highlighted why downside protection can be of use.”
Rosenbluth notes that the Defined Outcome funds are meant to be one part of a portfolio – “part of the toolbox that an adviser considers,” as he puts it. That’s the way the Innovator team describes their funds, as well.
He points out one caveat: “the fee is high.” That’s in part because a strategy like this requires some thoughtful management, but it’s also because Innovator is the only company offering this strategy. “As the first mover you don’t have to be as price-conscious,” Rosenbluth said. “Inevitably competition will come with not only a different buffer but also lower fees.”
For now, though, the Innovator products continue to attract a lot of attention and investor money: nearly $1 billion in just one year.