Last year I wrote a post about weird ETFs I own. I love these products, they allow you to take specific, sometimes exotic, exposures in a simple and cost effective manner (if you know what you are doing). When Michael & Ben in their Animal Spirit podcast interviewed the guy behind Innovator ETFs my hears were well open and smiling. These days I can listen to podcasts only when I am at the gym or running, since the commute to my office takes the same time to go from my bed to my kitchen; unfortunately, this topic is not exactly ‘podcast friendly’, I need to have the specs in front of me to follow the conversation, ideally with a couple of graphs. This was the first of a series of items that in the end made me archive the episodes as a meh and move on.
I know how the sausage is made
To create the Triple Stacker ETF, Innovator takes the dividend of the S&P500 plus the premium of selling an out of the money call on the same index to buy two collars, one on the Nasdaq and one on the Russell 2000.
My general distrust for structured products comes from the fact that each of the above pieces has a cost: the more the pieces, the higher the hidden costs. The basic of investing is to assess the risk/return profile of an opportunity and transactional costs reduce your return while the risk stays constant; add too many transactions and your expected return will not compensate you for the risk you are taking.
Limited upside with unlimited downside
If the three indexes are in the red after one year, your loss equals the S&P500 loss. Your loss is technically not unlimited because the S&P can only go to zero but I think already losing 50% of your investment, a drawdown the S&P had in multiple occasions in the past, feels like it?
While listening, my main concern was that over the long term the S&P500 had positive returns because it had many years of positive double digit gains. If you cap them at 7%, would you be able to recoup those years where it did -30%? Even if the S&P has a long term average yearly return of c7%, it very rarely finish a year in that neighbourhood.
The three indexes are positively correlated
The Nasdaq and the Russell 2000 are kind of S&P500 on steroids: when the S&P is positive, they gain more, and when is negative, they lose more (only in 2015 the Nasdaq closed green while the S&P was red…more on this later). This means that when the s**t hits the fan, they are not there to protect you, but when things are rolling, you do not get the full advantage because of the cap. There is no diversification benefit here.
This happened one year ago. Then Innovator came back on the same podcast and I decided to give it another chance. Maybe I can use the ETFs not as buy and hold but under specific circumstances? Given than you receive 100% of the S&P downside, ideally you want to avoid those down years. The issue with this strategy is that usually big down years are followed by big up years: if you have a strategy that successfully time the market, this is a suboptimal product because gains ace capped, you are better off investing in the standard index. These ETFs shine when the S&P is up between 0% and 7%, since you get (almost) 3x that return; but as I said, those years are quite rare and it is impossible to say when they will come.
Finally, one day, the proverbial lightning stroke: “Nicola, you used to back-test and validate these strategies as a job, you have Bloomberg, it will take you max 1 hour to check how the strategy have performed in the last 20 years”.
| Yearly Return | Std Dev | |
| Triple Stacker | 12.84% | 17.57% |
| S&P 500 | 7.62% | 17.70% |
Looks like doing your homework sometimes pays off.
Before you get too excited, read the small print:
- I deducted 70bps/year from the Triple Stacker ETF performance as difference between this etf cost and SPY, the ETF that replicated the S&P500 Index.
- The S&P performance does NOT include dividends; the real performance you get, especially if you invest in a Total Return product that automatically reinvest dividends, is higher.
- I used a constant 7% cap for the Stacker; in reality, the cap varies based on the S&P dividend yield and the implied volatility of the three indexes. This is what happens if you use a 6% cap:
| Yearly Return | Std Dev | |
| Triple Stacker | 8.44% | 16.46% |
| S&P 500 | 7.62% | 17.70% |
After one year, the ETF automatically rolls into a new structure, you should check the new cap and decide what to do; any cap lower than 6% is suboptimal.
Conclusion
When I was at Uni, other engineers were fast to judge Management Engineering (my diploma) as a fake engineering degree; the fact that it took me so long to check the numbers can only support their thesis. It is also a testament that you can spend years in finance and have your gut feelings wrong (ain’t no Soros here!). The Stacker gives you the performance of three correlated indexes: if you hit the cap, you normally get three times that cap and there are not so many years when the S&P gained more than 21%. This was the main element I missed and had to visualise.
Now I just have to hope that past the 31st of December, once UK is officially out of Europe and therefore MiFid, Interactive Brokers will allow me to buy US ETFs again…
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