By Lewis Braham
No downside risk -- it's the dream of every stock investor. While so-called buffer exchange-traded funds that hedge the downside risk on indexes like the S&P 500 have been around since 2018, they previously seemed like a bad deal. In exchange for a significantly capped upside of their benchmarks' returns, they typically protected investors only from the first 10% or 20% of market losses.
That's no longer the case, thanks to the newer 100% buffer ETFs. In the past year, four investment firms -- Innovator Capital Management, BlackRock's iShares, Calamos Investments, and First Trust -- have launched ETFs promising complete downside protection. And their upside caps, or maximum positive annual returns, are in the 8% to 11% range -- close to the long-term historical average return for stocks.
What changed? Interest rates. The return parameters of these ETFs depend on rates and the cost of options, which are used to get exposure to the S&P 500 and other indexes and to hedge that exposure. Because index options provide leveraged exposure, investors don't need to invest their entire portfolios in them to gain the equivalent performance of putting their entire portfolio in an S&P 500 stock ETF.
Instead, they can also hold cash or Treasury bills. The yield on T-bills -- what is known as the risk-free rate -- can help finance the cost of purchasing the options exposure. The higher the yield, the more options exposure one can afford, providing both more potential upside -- known as the cap rate -- and downside hedging.
Such 100% buffer ETFs weren't viable when rates were close to zero. But with T-bills yielding about 5% today -- and cash close behind -- you can get a 10% maximum upside cap rate with zero downside.
Because options have expiration dates, the ETFs' cap rates expire, too -- in six months, one year, or two years. The ETFs then reset with new caps, based on current options prices and interest rates.
The iShares Large Cap Max Buffer Jun ETF (ticker: MAXJ), has a one-year "current hedge period" of July 1, 2024--June 30, 2025. It has a "starting cap" of 10.64% and a "starting buffer" of 99.50%, after deducting its 0.50% expense ratio, so you'd have a maximum "starting downside before buffer" of -0.50%. (All of these ETFs' buffers are before fees.)
It's possible investors could execute this strategy themselves without fees. But aside from convenience, there's another benefit to the ETF route -- tax savings. The ETF structure is inherently tax-efficient, and these ETFs in particular employ complex options strategies to avoid taxable capital gains or income distributions.
The Innovator Equity Defined Protection ETF -- 1 Yr July $(ZJUL)$ invests in what are called "deep in the money" S&P 500 call options that embed T-bills' yields in the options' prices without actually receiving T-bills' taxable income. Interestingly, iShares chose a different route, as its buffer ETF holds shares inside its portfolios of the iShares Core S&P 500 ETF $(IVV)$, which pays dividends by holding stocks directly. (Options don't pay dividends.) Those dividends and the iShares Max Buffer ETF's lower fees have enabled it to have a higher cap rate than Innovator's 8.71%, yet dividends are also taxable.
These ETFs' most obvious risk is the opportunity cost if the S&P 500 rises more than their 8%-to-11% cap rates. But there's another, less obvious danger. If you invest after the S&P 500's value has already increased above an ETF's set price for the benchmark when it was first issued or during its annual reset, you will be exposed to any downside necessary to reach the ETF's buffer threshold again.
The iShares ETF, for example, disclosed on July 19 that it had a "remaining cap" of 9.44% and a -1.58% "downside before buffer." Always check buffer stats before investing.
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(END) Dow Jones Newswires
July 26, 2024 21:30 ET (01:30 GMT)
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