Defined Outcome ETFs: Pulling Double Duty

Defined outcome ETFs (sometimes known as “buffered ETFs”) have become increasingly popular over the course of 2022 as investors have come to appreciate their dual nature. They’re designed to protect against large downturns while also allowing for participation in rising markets. In fact, total assets in buffered ETFs have grown 80% so far this year and now total $16 billion, according to Bloomberg.<sup>1</sup> Do they deserve a spot in your portfolio?

How Do They Work?

Defined outcome ETFs (DOETFs) own options on an underlying index. In turn, these options create some form of payoff structure depending on the index’s return over a given period. For example, let’s assume we launched a defined outcome ETF in November that aims to shield investors against the first 15% of a market decline, while also enabling them to capture 20% of any upside over the next 12 months. Here’s how the payoff would look (Display):

Buffered ETFs Create an Asymmetric Payoff for Investors

Now imagine the market falls by 10% during the twelve months ending November 30, 2023. In this case, investors in the buffered ETF would emerge with their initial capital fully intact. Alternatively, should the market fall by 20% during the period, they would give up only 5%, rather than bearing the full brunt of the market loss.<sup>2</sup>

On the other hand, if the market surged by 20%, investors in this ETF series would enjoy all the upside.

What’s the catch? If the market advances by more than 20%, the additional gains are sacrificed. In other words, if the market soars by 30%, they’ll max out at the original 20%.

Besides pulling “double duty,” buffered ETFs appeal to investors for another key reason—liquidity. If the market moves sharply higher or lower in a short period of time, as we’ve seen multiple times over the course of this year, investors can quickly pivot. Those who no longer need the downside protection, or wish to reset at a different level, can trade out of their positions and into stocks, bonds, or another series of the defined outcome ETFs.

Now or Never

Investors who entered the year with buffered ETFs have been well served, securing “pre-set” outcomes while stocks have staggered. Yet despite recent strong performance, these strategies remain worthy options for the period ahead.

Amid heightened levels of macroeconomic uncertainty and volatility, defined outcome ETFs may continue delivering regardless of which path the market takes. If our bear case (a moderate recession and meaningful peak-to-trough market downturn) comes to pass, their cushion would provide attractive protection. At the same time, given the high price of volatility, investors purchasing buffered ETFs would lock in abnormally high upside potential today if a better scenario emerges and the market takes off.

Treat Your Portfolio Like an Orchestra

What role do buffered ETFs play in your overall asset allocation? Think of them as having a “slightly dampened” equity-like risk and return profile. While some investors might be tempted to move their entire stock allocation into buffered ETFs, we don’t recommend it. You’ll likely want to save part of your portfolio to fully benefit from any market gains that exceed the cap.

Beyond these strategies, there are other ways to create dampened equity exposure. For instance, you could build a barbell of stocks plus money market funds. How might that differ from a defined outcome ETF? The barbell would also reduce your gains and losses—but in a symmetrical fashion. In contrast, over the short-to-medium term, buffered ETFs have an asymmetric return profile, meaning they’re designed to capture more of the market’s upside than its downside. Longer term, their profile balances out to an expected return of around half the broad market, but with less volatility.

Let’s use concrete numbers to further demonstrate the point. Imagine an asset mix of 80% stocks and 20% money market funds (since it’s illustrative, we won’t include bonds or other asset classes). If the market fell by 20%, your hypothetical mix would drop by around 15.5%, while our earlier buffered ETF would decline by only 5%. Conversely, if the market rose by 20%, the barbell would deliver around 16.5%, while the buffered ETF would capture the full 20% gain.<sup>3</sup>

As a result, buffered ETFs can be a useful option for investors who are interested in taking some risk in the current markets but are still a little nervous about the macroeconomic backdrop and market direction and would prefer a smoother ride.

Past Performance, Future Outlook

With buffered ETFs having performed quite well in the recent market downturn, it’s little surprise that investors’ interest has grown. Yet as with any asset, we must ask whether recent strong performance will persist or if it’s poised to reverse direction.

Absent a crystal ball, it’s hard to say. What we do know for certain is that the combination of downside protection and upside participation adds attractive characteristics to certain investors’ portfolios. Elevated uncertainty and volatility also make this an ideal time to secure more upside than these strategies typically offer. Depending on investors’ risk tolerances, their existing portfolios, and their views on the world, those attributes may be worth considering in the current climate.

Matthew D. Palazzolo
Senior National Director, Investment Insights—Investment Strategy Group
Christopher Brigham
Senior Research Analyst—Investment Strategy Group, October 27, 2022.

2 Please note that investors in the S&P 500 would expect to benefit from ~1.8% in dividends over that period while investors in the buffered ETF would not. However, relative to the price move, that dividend would offer little consolation.

3 These calculations include the stock market return plus the yield on money markets of around 2.5%, which we’re holding constant at current levels in these estimates.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

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