Weekly Market Commentary | October 28th 2024

Types of Defined Outcome ETFs

While a detailed examination of their structural design is beyond the scope of this discussion, Defined Outcome ETFs generally fall into three primary categories:

• Funds With Upside Cap: These funds buffer a range of losses while capping returns beyond a certain point. This is the most common approach.
• Funds With Partial Upside Exposure: These ETFs provide downside protection by capturing only a portion of positive index returns instead of implementing a cap.
• Downside Floor: This strategy may offer maximum loss protection in an extreme down market with a lower cap on gains which may provide returns higher than CDs or Treasury bills. However, in a market with “average” volatility, it may offer no protection at all.

Some providers also offer fund-of-funds structures aimed at providing more flexibility, albeit with higher fees and fluctuating upside cap.

Cost of Protection

While Defined Outcome ETFs offer attractive benefits, they come with certain trade-offs:

• Higher fees (typically 70-80 basis points above traditional S&P 500 ETFs)
• Most do not pass through dividends from underlying stocks
• Capped upside potential may result in missed gains during strong market rallies

 The effectiveness of Defined Outcome ETFs depends on several factors:

• Market Performance: The actual performance of the underlying index or asset during the outcome period
• Buffer Level: The amount of downside protection offered by the ETF
• Cap Level: The maximum return potential of the ETF. It is occasionally referred to as the Cap Rate, though this term has a distinct meaning in the context of real estate investments.
• Timing: When an investor enters and exits the investment relative to its outcome period
• Fees: The expense ratio of the ETF

General Investment Structure and Investor Outcomes

Defined outcome ETFs use options strategies, making them complex before option expiration. Options have two values:

• Intrinsic value: The difference between strike price and underlying security price
• Extrinsic value: Additional value based on time until expiration and market volatility

At expiration, options are valued only on intrinsic value. Before expiration, most options in these ETFs have both intrinsic and extrinsic value.

The ETF’s price change relative to the S&P 500 depends on the cumulative “delta” of its options. Delta measures how much an option’s price changes when the underlying security’s price changes.

Moreover, these funds reset annually, offering a new upside cap and refreshed protection for the next 12-month period.

Defined Outcome ETFs represent a notable innovation in the ETF landscape, offering investors a tool to potentially manage risk while maintaining exposure to equity markets. Matt Kaufman, Head of Calamos Investments, notes that Buffer ETFs may present a potential solution for a large demographic of retirees by addressing longevity risks and combating inflation for this group. However, investors should carefully evaluate their personal risk tolerance, market expectations, protection costs, associated risks, and investment horizon before incorporating these products into their portfolios.

Financial professionals should be aware that Cambridge classifies Defined Outcome ETFs as liquid alternatives. As such, these investment products are subject to specific concentration guidelines that apply to Non-Conventional Funds and Traded Securities.