While the U.S. stock market has repeatedly made new all-time highs, it is essential to remember that stocks don’t go up in a straight line forever. Perhaps the relentless climb of stock prices has caused many investors to forget about the importance of having protection in their portfolios to guard against such corrections.
“Defined outcome investments” is a tool growing in popularity that allows investors to maintain exposure to equity markets while shielding their portfolios from at least a portion of the losses if the markets were to fall. However, while this type of investment can play an important role in your portfolio, like everything, there are trade-offs and fully understanding the pros and cons are vital in determining if they are appropriate.
Defining the Parameters
So what are “defined outcome investments”? These investments set parameters around the potential outcomes an investor can expect to achieve over a certain period. They are often designed to be passively managed investments that track the performance of a desired index, like the S&P 500.
However, many tend not to invest in stocks directly. Instead, they use a series of derivatives called put and call options to create a buffer zone in which the investment is protected against a decline and often a ceiling above which the investment cannot break. The use of these options effectively “defines” the likely range of outcomes – the performance will be protected against losses within the buffer zone, but capped by the ceiling.
These investments have been created to track various types of investments, ranging from large-cap or small-cap U.S. stocks, international stocks, or even REITs. They also can come in different types of structures (like ETF or structured notes, to name two), each offering unique features.
ETFs are the fastest-growing kind of these defined outcome products, providing easy access for all investor types since they can be purchased at any time with no minimum investment. Structured notes, on the other hand, can offer more customizable solutions for clients who work with advisors with large enough scale to be able to negotiate terms directly with banks.
Too Good to Be True?
The ability to protect against potential losses in your portfolio is an attractive feature of these types of investments; however, “there is no free lunch.” Investors in these products typically forgo the dividends that the index pays out, and with ETFs, this downside protection must be paid for by capping the upside growth potential.
For example, let’s consider Innovator Capital Management’s series of ETFs, one of the largest players in the space. The Innovator January S&P 500 Buffer ETF (Ticker: BJAN) is designed to last for one year and to track the S&P 500 Index with a 9% buffer (which protects against the first 9% of losses, but is exposed to any incremental downside if the market were to decline further) and a 13.3% cap on the upside return.
For investors interested in more downside protection, products also exist that protect against, say, the first 15% of losses and even others protecting against more significant declines of 30%.
As you might expect, increased downside protection comes at an increased cost—namely a lower cap on the potential upside. So while these investments can protect your account from losses if the market falls, the capped upside may cause your portfolio to significantly underperform if the market has a repeat of 2019, where the S&P 500 increased over 31%. Insuring your investment against losses can be quite costly!
Structured notes are more customizable and can be designed to not only provide protection against market declines, but also amplified upside participation when markets rise. Sounds like the best of both worlds, right? But there’s a catch. Structured notes are often designed to be multi-year investments, meaning they are less liquid, and it is more challenging to sell the investment at a fair price before maturity. Also, as an owner of a structured note, you are technically a creditor of the issuing bank, which is an additional risk that ETF investors do not face.
So are “defined outcome investments” right for you? With markets at historically high valuations, adding a level of protection into your portfolio may be a prudent step to take. However, as each investor’s situation and portfolio are different, it is best to talk with your financial advisor to determine if these investments should play a role in your portfolio.