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Defined outcome funds until now have only offered investors a degree of downside protection © AFP/Getty Images

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The world’s first exchange traded fund to offer 100 per cent protection against losses launched in the US on Tuesday.

The Innovator US Equity Principal Protected ETF will stretch the increasingly popular “buffered” ETF concept to its limit.

“This is something that we have been looking at for a number of years,” said Graham Day, chief investment officer of Innovator Capital Management. “We have started to see a lot more interest in this type of product.”

To date, “defined outcome” funds have used derivatives to offer investors a degree of downside protection — in return for surrendering some of the potential gains — without endeavouring to protect against all losses irrespective of how the market performs.

Innovator’s flagship Power Buffer range, for example, aims to protect investors against the first 15 per cent of market losses over six months or a year, but no losses beyond that.

Defined outcome ETFs took off during last year’s turbulent markets, raking in a net $10.9bn in North America, the most developed market, alone — up from what had been a record $4.1bn in 2021, according to FactSet.

Despite better market conditions this year, they pulled in another $4.6bn in the first six months, even before BlackRock, the world’s largest asset manager, launched its first funds, potentially kick-starting a price war.

The Innovator US Equity Principal Protected ETF is focused on the S&P 500 index and will use a series of put and call options to attempt to protect against any market losses over a two-year period. Further funds are due to be launched at six-monthly intervals.

Investors could still be left out of pocket, however, given that the buffer is calculated before the subtraction of annual management fees, transaction fees and any “extraordinary” expenses incurred by the fund. Annual management fees are expected to be 79 basis points.

Market conditions, particularly the levels of volatility and prevailing interest rates, determine the level of the “cap” — the maximum return the ETF can generate over the two-year period.

Day said he expected the debut ETF to launch with a cap of 15-18 per cent over the two-year period, or 7.1-8.8 per cent on an annualised basis. In common with other products offered by Innovator and its rivals, investors forgo dividend income.

As a comparison, since 2019, Innovator’s monthly series of S&P 500 Buffer ETFs — which protect against the first 9 per cent of losses — have had an average cap of 17.4 per cent over a 12-month period. 

Its Power Buffer range — offering 15 per cent downside protection — has had an average upside cap of 11.9 per cent, and its Ultra Buffer range — protecting against losses from -5 per cent to -35 per cent — of 9.7 per cent.

Innovator, which with $13.5bn in assets is the largest provider of defined outcome ETFs, is pitching the new fund as a way to “disrupt” the market for products offered by insurance companies, as an alternative to the “archaic” annuities market.

Sales of fixed-indexed annuities, which offer principal protection, rose 42 per cent year on year to $23.1bn in the US in the first quarter of the year, setting a record for the third consecutive quarter, according to the Life Insurance Market Research Association.

“Trillions [of dollars] have come into the economy [as a result of the Covid stimulus programmes] but are sitting on the sidelines in cash, in money market funds and bank deposits,” said Day.

Yet historically, he argued, increasing exposure to equities, even with an upside cap in place, produces returns that exceed cash over time.

“If [an adviser has] clients who are overweight cash or short-term bonds, if they can dip their toe into the market and still have that 100 per cent buffer in place, there is a market for that product,” Day added.

Innovator claims the ETF structure offers several advantages over annuities, such as daily pricing and liquidity, the ability to buy and sell during the product’s life, no minimum purchase size, no withdrawal or surrender charges and greater tax efficiency.

Not everyone was convinced by its merits, however.

“If investors are seeking to avoid market risk altogether, I would question whether they should be participating in stocks in any format — let alone a strategy with relatively high fees and offering no dividend payments,” said Nate Geraci, president of The ETF Store, a financial adviser.

Bryan Armour, director of passive strategies research, North America at Morningstar, compared the strategy to “owning Treasury bills, but betting the coupons on the hopes of slightly bumping [up] the yield over the course of the outcome period. The upside narrowly beats the risk-free rate.”

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Despite this, Armour did think it was an “interesting product”, but warned that derivatives-based collar strategies, which the ETF relies on to generate its pay-off structure, “can work against you during irrational markets, like in 2008 or 2020 when demand for put options was overwhelming”.

Moreover, he believed cash management could be “tricky”, especially if the fund sees significant inflows during periods of market stress when puts are priced more expensively.

“Personally, I would rather hold two-year Treasuries, which are as close to a guarantee as investors can get and currently yield 4.9 per cent,” Armour said.

Geraci noted it was “entirely possible returns fall meaningfully short of that upside cap”, when investors “can currently scoop up 5-6 per cent yields with minimal risk in short-term bond ETFs”.

“That said,” he added, “I do believe these types of defined outcome ETFs will continue taking market share from annuities and other traditional structured products, which can be even more expensive and complicated, not to mention illiquid and possessing non-zero credit risk.”

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