No Downside?

New ETFs offer 100% protection. But at what cost?

What if I could make you a deal – over the next year you can earn as much as 8% (and no more) in stocks, but with no chance of losing money? In other words, if stocks go up 8%, you make 8%; if stocks go down 30%, you make 0%. 

However, if stocks went up 30%, you would still only make 8%. 

Sound good? Would you do it? 

Well, there’s a popular new style of ETF available that allows you to essentially take such a deal. They’re called buffer or defined outcome products. A company like Innovator allows you to mix and match all kinds of similar deals where you can “buffer” your downside while putting a “cap” on your upside. 

The PJAN ETF, for example, protects you from the first 14% of losses and caps you at the first 13% of gains from Jan. 1 to Dec. 31. I recently put some money into the ZAUG ETF, which aims to protect you from 100% of losses while offering 8% of gains from Aug. 1 to July 31. And that’s part of the deal, you have to hold these products for the entirety of that period to get the full protection or gain. 

This is a similar concept to certain annuity or insurance products that may have offered you principal protection and steady returns, but with more liquidity and transparency. I’m not going to get into the nitty gritty, but defined outcome ETFs use options rather than credit instruments (like with annuities) to set up these payoff profiles. You can read more about that process if you’re interested.  

What are the Risks? 

Some of have said these products sound too good to be true, but the most obvious risk is the loss of upside. Imagine a two year stretch where in year one, stocks are flat and in year 2, stocks go up 20%. Assuming you were taking this deal of 8% upside and zero downside, you’d only be up 8% over those two years, instead of the 20% the market returned. 

Stocks tend to go up most years, so you could be paying for downside protection you don’t really need, while severely limiting your upside. 

Because these are tied to the “outcome period” you also won’t be able to sell them during a sharp market downturn and buy stocks. They’re not going to stay at 0% while the market drops 20%, there will be dips during the period before you’re made whole.

At the same time, we should also consider the risks of being fully invested in stocks. Since the year 2000, the SPY ETF, which tracks the S&P 500 has dropped 55%. Imagine for a second having $1 million and having it turn into $500,000. Could you go on? Could you hang in there? 

The QQQ ETF, which tracks the growth oriented companies of the Nasdaq 100 at one point went down – are you ready for this – 83%! Yes, you read that correctly. This is why I believe in diversification. Imagine your $1 million turning into $200,000. 

So while it’s important to point out that even if stocks deliver 8% per year on average over a period of time, one of these products may not give you that same return even with the 8% cap, because it has to take place during a defined timeframe; I think it’s also worth considering how we can participate in the upside of stocks without some of the extreme risks.  

Use Case

One of the things I think about all the time is how to create a risk balanced portfolio within a taxable account, while still maintaining tax efficiency. Stocks generally receive pretty good tax treatment (long term capital gains tax rates, qualified dividends), but bonds do not (you pay ordinary income tax on the interest). So assuming you’re not comfortable being all in on stocks, how do you diversify the portfolio? Bonds, gold and managed futures are all tax inefficient investments.

These buffered, defined outcome products, however do not pay out dividends (which you’re taxed on whether or not your investment makes money). You only pay capital gains when you sell them. My thinking is if they’re part of the conservative portion of my taxable portfolio and I can get bond-like returns without the bond tax treatment that would be a win. 

There are a couple issues with this approach. One is even though you’re getting protection from equity drawdowns, you’re still tied to equity performance. So if stocks do really bad, you won’t do really well, you’ll just do not as bad. You may not lose money, but you won’t make any.

It’s also just a bit of an esoteric, unproven strategy and I wouldn’t feel comfortable putting too much at stake. In fact, I’m not comfortable putting too much at stake in any particular strategy. 

Still, I think this could be a component of a conservative approach along with cash, bonds, maybe trend following, etc. 

At the end of the day, you may not want to over-optimize for taxes anyway. You wouldn’t want to make less income from your job, just so you wouldn’t have to pay as much in taxes.  

There really is no way to fully mitigate risk. There is always a downside. But that doesn’t mean I won’t at least try to prepare for a variety of scenarios in a variety of different ways. And there are lots of new tools emerging to do so, for better or worse.    

This is not investment advice. I have a small position in ZAUG.