Defined-Outcome Strategy ETFs

Global X just launched two “defined-outcome” ETFs that are UCITS compliant (i.e. can be bought by European Investors):

• SPQB, the S&P500 Quarterly Buffered UCITS ETF,
• SPQH, the S&P500 Quarterly Tail Hedge UCITS ETF.

I thought I already wrote about this strategy, but I realised I only did a generic piece on structured products here.

Innovator ETFs launched the first defined-outcome strategy ETFs about three years ago. It is a bit funny to look back because, alongside them, they also launched the Triple Stacker ETF strategy. I got interested in the latter more than the former and wrote about it here. Guess which strategy was a commercial success? The Stackers have a paltry AUM and, most likely, will be closed shortly while the Defined-Outcome strategy has been a home run. That’s why Global X is trying to ride the same wave in Europe.

The Defined-Outcome Strategy

The Global X website offers a neat explanation of the strategy, but since I know you are lazy, I will put an excerpt here.

Defined-outcome strategies, utilising a combination of put options and call options on a specified reference asset, provide a specified level of downside protection with equity upside participation, up to a cap. The key purpose of this type of option overlay is to provide a level of risk mitigation that is predictable and specified to the investor, should this type of strategy be held from the initiation of the option contracts to contract expiration.

The above graph is easy to understand if you are familiar with option pay-offs but let’s break it down:

• the “quarterly” in the ETF name means that the strategy buys/sells options with a three-month maturity every quarter. This is a key element to understand because the cap and the buffer levels are only valid if the ETF is held from the options start date until maturity. If you buy the ETF on any other day, your return will still be capped and buffered but those levels would depend on where the market has gone since the last option reset. SPQB offers a 5% buffer but only if you buy the ETF at quarter end and keep it for the whole three-month period; on any other day, the buffer might be higher or lower than that.
• Your maximum quarterly gains are capped. If the market explodes on the upside (think about Q2 of 2020), you will only get part of that gain. But the cap is reset quarterly, so if the market goes up moderately but constantly quarter after quarter, you might get all the gains.
• you have defined buffer protection but that is consumed, the loss can still go up to (theoretically) 100%.

Consequences of the strategy

“Investors hate uncertainty” is a well-known truism. The only real defined outcome with this product is the maximum upside an investor can achieve; or how misleading is calling a product “defined outcome” when the scenario investors care about most, how much they can lose, is not defined at all.

It is impressive the marketing craft salespeople achieved when pushing these products. They never say that the downside is defined, which would be a lie, but that’s the message they deliver.

“There is no guesswork with what Innovator Buffer ETFs deliver, and PJAN is no exception. We know the upside we will capture, and we know the downside buffer we have in place” (from this interview between NomadicSamuel and Innovator ETF).

I am a “reformed lover” of Covered Call strategies and I wrote about their pitfalls here and here. In short, to reduce a bit the left tail, investors are giving up a big chunk of the right one. The only difference here is that the investor is using the dividend generated by the underlying index to buy a part of the buffer (the other part is paid by the level of the cap)…incurring some additional trading costs in the process.

It is again a bit of marketing sleight-of-hand, put in the brochure the product equity line compared to the S&P500 index PRICE RETURN and not TOTAL RETURN (i.e. including dividends).

Is there a better solution?

The Global X products are new to the market so there is not much history to look at, but I can use the Innovator ETFs as proxies. The strategy is the same, the only difference is that Innovator rebalances annually while Global X does it quarterly.

PJAN is the Innovator buffer strategy that rebalances each January. It offers a 15% buffer but, again, it works on an annual horizon: we cannot compare this 15% with the 5% of Global X that protects on a quarterly basis (there should be some math to say what 15% means on a quarterly basis but I am too lazy to check. What I want to show is just how they generally perform). Both graphs are taken from the NomadicSamuel interview I linked before.

2022 was the ideal year for the defined-outcome strategy because the S&P500 had a more or less constant and steady decline. The comparison works extremely well for Innovator because the market topped at the end of Dec-21; using any other buffer ETF of the same series that rebalance on a different month would deliver a less optimal picture.

2020 is a more interesting example because it can be read in different ways. Both PJAN and SPY had a sensible decline at the beginning of the year and both ended up in positive territory at the end. SPY had a more pronounced decline but it also finished with a bigger gain. The only way a SPY investor would have lost money is if they panicked in March and sold, but this is also true for a PJAN investor. The key difference is how much drawdown an investor can stomach.

So let’s take a step back and try to see the bigger picture. I have built an equal-weighted portfolio of the 12 Power Buffer ETFs to create a strategy that has a monthly 1/12th rebalance (this avoids any market timing rebalance luck/misfortune):

This is how this portfolio performed since its inception against SPY:

Do you notice the relationship between CAGR and Max Drawdown in the two cases? Looks almost like a SPY investor can achieve the same result as the Power Buffer portfolio by just investing half of the amount…well it is more like 40% in SPY and 60% in cash:

Innovator has another series of buffer ETFs, this time providing a 9% buffer. As you can see, it is the same story when compared to SPY:

And when compared to a 57/43 portfolio of stocks and cash:

There is a pretty simple conclusion for me: if you are afraid of stocks’ drawdowns, just invest less in stocks. That’s it.

There is a behavioural aspect that might still work in favour of the buffer ETF: “investors” are not able to look at portfolio results but focus on every single line item. They do not see what cash PLUS stocks delivered, they look at stocks and think “oh s^%t, they are down 30%, let’s sell everything”. This behaviour is well documented…empirically. It is the reason why many trend following managers include a stock-beta component to their funds, not because it improves performance but because it helps to sell the product to clients that would otherwise fire the manager when it underperform stocks…even if the mandate is not that at all. I spent the last four years managing a portfolio of funds and inevitably, every quarter, I received questions about the worst performing fund, not on how the portfolio AS A WHOLE delivered.

The fact that a buffer ETF can be replicated by a portfolio of stocks and cash makes sense because you can replicate a long-call option payoff with a long position in the underlying asset and borrowing cash (the reverse in case of a long-put payoff). Based on this, it is also clear that marketing these funds as alternatives to bonds is no bueno.

Bonds are not always inversely correlated to stocks but they offer, in the long term, higher returns than cash. The fact is, if you move from a portfolio of only cash and stocks to one that is stocks, bonds and cash, you can improve the return for the same amount of risk (or vice-versa). But to formalise this, we would have to first agree on what “risk” means: volatility? downside volatility? Max drawdown? Ulcer index?

PortfolioVisualizer has a very rough Efficient Frontier tool but its output might explain better what I mean:

Unless you want a portfolio with very low volatility (4% or less), you are better of including Bonds in your asset allocation (and these defined-outcome strategies are not an alternative).

Unfortunately for you reader, I cannot end this post without mentioning trend following 😉 Instead of combining SPY with cash, looks what happen if you marry it to DBMF:

I have also to mention that, so far, March has been a terrible month for DBMF while the defined-outcome ETFs are doing fine. You will probably see the Innovator ETFs guy gloating on podcasts for a while…

What I am reading now:

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