Innovative Stock ETFs Offer Complete Price Protection, But At What Cost?

The dream of every stock investor is to eliminate downside risk while enjoying the potential for gains. Enter buffer exchange-traded funds (ETFs), which hedge against market downturns. Initially launched in 2018, these ETFs protected investors from the first 10% to 20% of market losses, but at the cost of significantly capping the upside. However, the recent introduction of 100% buffer ETFs has changed the game, offering full downside protection and more competitive upside caps. Four investment firms—Innovator Capital Management, BlackRock’s iShares, Calamos Investments, and First Trust—have rolled out these promising products, but they come with their own set of risks and nuances.

The concept behind 100% buffer ETFs is straightforward yet intricate. These funds use options to provide exposure to indexes like the S&P 500 while hedging against potential losses. The key factor that has made these ETFs viable is the rise in interest rates. Higher rates have allowed these funds to buy options while holding cash or Treasury bills (T-bills), which now yield around 5%. This strategy provides both a downside hedge and a cap on the upside, typically ranging from 8% to 11%, which aligns with the historical average returns for stocks.

Key Players and Their Offerings

Each firm has tailored its buffer ETF to offer unique benefits:

Innovator Equity Defined Protection ETF—1 Yr July (ZJUL): Utilizes “deep in the money” S&P 500 call options that embed T-bills’ yields in the options prices. This approach avoids taxable income from T-bills directly.

iShares Large Cap Max Buffer Jun ETF (MAXJ): Holds shares of the iShares Core S&P 500 ETF (IVV) within its portfolio. While this means dividends are taxable, it allows for a higher cap rate due to lower fees.

The ETFs have specific periods during which their protection and cap rates apply. For instance, the MAXJ ETF has a one-year hedge period from July 1, 2024, to June 30, 2025, with a starting cap of 10.64% and a starting buffer of 99.50%, after accounting for its 0.50% expense ratio. This means that the maximum downside exposure before the buffer kicks in is -0.50%.

Given the nature of options, these ETFs reset their cap rates periodically—every six months, one year, or two years—based on the current prices of options and prevailing interest rates.

One significant advantage of these ETFs is their tax efficiency. The ETF structure helps in avoiding taxable capital gains or income distributions. For example, while the iShares ETF pays dividends by holding taxable stocks directly, the Innovator’s ETF structure avoids direct receipt of T-bills’ taxable income.

Despite the allure of downside protection, these ETFs are not without risks. The most apparent risk is the opportunity cost if the S&P 500’s performance exceeds the ETFs’ cap rates. Investors could miss out on significant gains beyond the 8%-11% caps.

Another critical risk is the timing of investment. Suppose an investor buys into the ETF after the S&P 500 has risen above the benchmark set at the ETF’s issuance or during its reset. In that case, they will be exposed to any downside necessary to reach the ETF’s buffer threshold again. For example, the MAXJ ETF disclosed a remaining cap of 9.44% and a -1.58% downside before the buffer as of July 19, highlighting the importance of checking buffer stats before investing.

Interest rates play a pivotal role in the functionality and appeal of these ETFs. When rates were near zero, the cost of hedging through options was too high, making such complete protection ETFs impractical. However, with current yields on T-bills and cash close to 5%, these products have become more attractive. Higher yields mean that ETFs can afford more options exposure, resulting in better upside potential and robust downside protection.

100% buffer ETFs represent a significant evolution in investment strategies, offering full downside protection while providing a reasonable cap on gains. While they offer intriguing benefits, including tax efficiency and protection against market losses, they also carry risks related to opportunity cost and timing of investment. As always, investors should carefully consider these factors and stay informed about the specific terms and conditions of the ETFs before committing their funds.

While the 100% buffer ETFs are an attractive proposition for risk-averse investors seeking to mitigate potential market losses, it is essential to weigh the benefits against the potential opportunity costs and timing risks. As with any investment, thorough research and a clear understanding of the product are crucial.