Author | Cao Tian
Edit | xiaopi
In investment, low risk, high return and high liquidity have always been impossible triangles. The weight given to each indicator is the comprehensive consideration of investors on income, age, expenditure and other factors.
Young people just entering the society yearn for high returns, all in equity investment. At this stage, the principal is small, and even if they lose money, they will spend money to buy experience; When people reach middle age, they have to think more about it. There are old people and young people. The monthly expenditure is rigid. At this time, assets should be distributed and money should be available to deal with unexpected events; After entering old age, investment will tend to be conservative, and the most important thing is to avoid returning to poverty after retirement.
In recent years, buffered ETFs have shown great success overseas. In addition to using financial derivatives to manage downside risks, these products have also absorbed the advantages of ETFs: good liquidity, low rate, low threshold, etc.
One of the key questions of investment buffer ETF is: how much income are you willing to give up in order to control risk?
In 2006, the PowerShares jointly founded by Bruce Bond and John Southend was acquired by Invesco, making the latter the fourth largest ETF issuer in the world. John Southard, one of the co founders, was going to retire, but when he was managing his own money, he found that the structured products on the market could not meet his needs.
At that time, most of these products were structured notes and insurance. Although they could provide downside risk protection to a certain extent, they had high fees, poor liquidity, high net worth customers, credit risk, and locking fees
John believes that there is a strong investment demand for downside risk management in the market, but there is not enough effective supply of financial products.
In 2017, he and Bruce Bond joined hands again, first acquiring Innovative Funds, and then transforming them into an Innovator capital company. They innovatively combined structured products with ETF, and issued the first buffer ETF in 2018. Since then, a new category in the ETF field has been born.
About 75% of the funds in the US market are in need of retirement, especially the baby boomers (people born between 1946 and 1946) have entered the retirement age. These investors pay more attention to risk control than earnings.
Chinese investors tend to be steady as a whole. The proportion of equity assets in household allocation is not high. In addition, the volatile market in the past two years has made investors extremely risk averse.
In addition, under the fierce aging trend, the demand for funds to save for retirement has increased. How can we use the capital market to enrich pension investment channels and meet the financial needs of retirees? Perhaps the buffered ETF is a reference.
How to control risks?
Buffer ETF (also known as Defined Outcome ETF) is the same as the covered option ETF previously introduced: derivatives are used to control volatility. This type of product is designed to provide downside protection, which is why it is named: it cushions downside risk.
Previously, the downside risk protection range of buffer ETFs issued in the market was 9%, 15% and 30%. Recently, a company named Calamos announced the launch of 12 100% downside protection buffer ETFs. This means that this fund ignores management fees and has no losses. Can such an ideal investment result really be achieved?
Buffer ETFs provide investors with loss protection for the fixed degree of underlying assets within a certain period of time at the cost of a certain limit on growth. This type of product will set a buffer ratio and a cap for rising limit.
In fact, Calamos is not the first person to eat crabs. In July 2023, Innovator released the Innovator Equity Defined Protection ETF (code TJUL), which is linked to the S&P 500, provides 100% downlink protection, a two-year agreed revenue period, and a maximum of 16.62% (pre fee revenue, the same below) revenue.
Since its launch in July last year, TJUL has also tracked the trend of the S&P 500, and its volatility is significantly smaller than that of SPY.
As far as the asset structure is concerned, the buffer ETF does not hold any bonds or stocks, and essentially a basket of Flex options with different strike prices.
Flex options are traded on the Chicago Board of Options Exchange (CBOE). Its contract terms (such as exercise price, exercise method, expiration time, and linked subject matter) can be customized. At the same time, its liquidation is completed by Options Clearing Corporation, which has almost no credit risk.
According to the introduction on the official website, TJUL's operation is divided into three levels:
The first layer is to obtain the return of 1:1 of the underlying asset, and obtain the risk exposure of the underlying index by buying a long call option with a very low exercise price;
The second layer is to set buffer protection. By buying put options with higher strike price, this determines the scope of buffer, which will generate negative cash flow;
The third layer makes up for the negative cash flow of the second layer by selling call options. This transaction limits the maximum return of the portfolio and constitutes a cap. The exercise price is uncertain, depending on the fund gap caused by the second layer transaction, and is used to support the cost of the second layer put spread.
In different market scenarios, TJUL has roughly three performances:
No matter whether the market falls by 100% or 30%, TJUL's loss is zero due to 100% downside protection;
If the market rises by 10% and does not exceed the upper limit of TJUL by 16.62%, the fund will obtain a return equivalent to the S&P 500 trend, that is, 10%;
If the market rises by 25%, exceeding the income limit, the fund's income is limited to 16.62%.
Really can't lose?
Buffer ETFs with bottom support look good, but investors need to note that for investors, the Buffer and Cap promised by the fund will be fully realized on the maturity date. Such ETFs have an agreed income period, most of which are one year. After the maturity, these two indicators will be re balanced.
In operation, the ETF tends to rise and fall with the underlying index, but the overall volatility/fluctuation will be smaller than the underlying index, because the existence of derivatives smoothes the volatility of the fund.
Taking TJUL as an example, the agreed yield period of this product is about 2 years, and the agreed yield ceiling of 16.62% will be readjusted after expiration. The manager will liquidate the currently held option position and establish a new option position according to the structure agreed in the fund contract.
Among them, the downward buffer is generally fixed, but the yield limit should be reset according to the market environment after expiration. Generally speaking, the higher the market volatility, the higher the yield ceiling, and the lower the volatility will provide a lower yield ceiling.
This means that if investors trade within the agreed return period, you will get a lower buffer and a higher yield limit than advertised.
For example, the 16.62% of the income promised by TJUL is the return on the first day of purchase and holding (about two years). If the investor trades in the middle, the return will be different. The actual buffer range (i.e. the fall protection range) and the upper limit of the return depend on the time point of purchase.
Buffer ETFs have an issue price at the time of issuance, and its price changes in subsequent operations.
If the structured ETF is purchased below the initial price, the buffer range will decrease and the upper limit of earnings will rise; If you buy at a position higher than the initial price, you need to bear some losses before enjoying buffer protection, and the upper limit of income will be reduced.
Assuming that the underlying index falls by 1% the next day, the ETF has 10% downside protection. Although it will not suffer from losses, there is only a 9% buffer zone left.
Similarly, if the target index increases by 1% and then buys the ETF with a ceiling of 8.5%, then there is only 7.5% potential upside left. Therefore, investors should pay attention to the market trend and the timing of intervention when buying buffer ETFs.
Risk management vs yield abandonment
Since its launch in 2018, buffer ETFs have been attracting capital inflows. In particular, after the stock and debt turbulence in 2020 and 2022, the sharply fluctuating market highlighted the downside risk protection selling point of buffering ETFs, which attracted more than 20 billion dollars in the past two years.
Just like the original intention of buffering ETF, investors are afraid of missing the opportunity of market rise, but also afraid of the risk of decline. Therefore, buffering ETFs enables customers to enjoy the market rise and do a good job in risk management.
Of course, buffering ETFs also has some obvious disadvantages.
First, they are not cheap. The fee ratio of innovator's funds related to SPDR S&P 500 ETF is often 0.79%, which is much higher than that of the basic ETF (0.09%).
Secondly, at present, there are many high-yield products in the United States. Under high interest rates, we can obtain considerable and safe returns through other securities.
For example, the current yield of two-year US treasury bonds is 4.9%, which means that by purchasing the safest asset class in the world, we can lock in about 10% of the yield, which is equivalent to two-thirds of the potential upside of TJUL in the next two years. In this way, it seems that the price performance ratio of buffer ETF is not high.
Finally, there is a huge opportunity cost for holding buffer funds. If the rise of the underlying index exceeds the exercise price of the call option, these gains will be missed. Especially in the unilateral rising market, investors have to pay more opportunity costs.
Therefore, some people say that for ordinary investors, holding broad based index ETFs (such as the S&P 500ETF) is the best investment. In the past 30 years, the SPDR S&P 500 (SPY) ETF has achieved a compound annual return of 10.54%.
Indeed, compared with the trend of TJUL and SPY, TJUL outperformed the latter in other time dimensions except for the earnings of nearly a month.
For most investors, fluctuations in the stock market can be smoothed out by lengthening the investment cycle. But for a person facing retirement, the 20% withdrawal means that when others are basking on the beach in Naples, he will have to work for another two or three years.
As the old saying goes, there is no free lunch for investment. As a configuration tool, the buffer ETF can help to build a portfolio that meets the investment objectives. In the final analysis, it depends on how many returns investors are willing to give up in order to control risk, and ultimately depends on their risk tolerance and judgment on the market trend.
As a "rookie" in the field of ETF, the increasing scale of buffer ETF fully proves the market space of such products. Whether it is 9%, 15% or 100% decline protection, it meets the risk demands of different degrees. Everyone has their own considerations about the calculation of risks and returns. There is no standard answer to the investment.
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Source of this article: Guangshu Lightell, author: Cao Tian, editor: xiaopi, original title: "Steadily earn, never lose", really exist
