Review of 100% Downside Protection ETFs

Summary: This briefing document analyzes the key features, benefits, and drawbacks of 100% Downside Protection ETFs, a new category of defined-outcome ETFs offering full principal protection in exchange for limited upside potential. The analysis is based on insights from Morningstar, Invesco, Calamos Investments, and BlackRock iShares, providing a comprehensive understanding of these investment vehicles.

Main Themes:

1. Downside Protection Mechanism: These ETFs utilize options strategies, specifically buying put options to hedge against losses and selling call options to finance the put purchase. This creates a defined outcome range with a floor of 0% return (gross of fees) and a predetermined upside cap.
2. Upside Cap: The upside cap is typically linked to the prevailing T-bill rate for the option’s duration plus a spread. While higher than a simple T-bill investment, the cap limits potential returns compared to the broader stock market.
3. Outcome Period: The defined outcome only applies if the ETF is held for the entire predetermined outcome period, which can range from six months to two years.
4. Target Investor: These ETFs are primarily suited for investors prioritizing capital preservation with short-term liquidity needs or investment horizons. Examples include individuals planning large purchases or retirees starting withdrawals.
5. Key Providers: The main providers offering these ETFs are Innovator, First Trust, Calamos, and BlackRock. Each provider offers variations in terms of underlying indexes, outcome periods, and fee structures.

Important Ideas/Facts:

• Trade-Off: The central concept is the trade-off between downside protection and limited upside potential. “These ETFs trade in upside for downside protection. They buy a put option to protect against all losses on the underlying security and sell a call option to finance the purchase.” (Morningstar)
• Suitability: “These strategies work best for capital preservation…for investors with short-term liquidity needs or a short investing horizon.” (Morningstar)
• Calamos’s Perspective: Calamos Investments emphasizes various scenarios for potential entry points, including when the market is at or above the Day-1 ETF NAV, offering investors different risk-reward profiles.
• BlackRock’s Approach: BlackRock’s iShares Large Cap Max Buffer Jun ETF (MAXJ) employs a slightly different approach by physically holding the underlying ETF (iShares Core S&P 500 ETF) and using a small allocation to S&P 500 futures for additional efficiency.
• Invesco’s Focus: Invesco S&P 500 Downside Hedged ETF (PHDG) is actively managed and uses a dynamic allocation strategy between S&P 500 components, volatility hedges via the VIX Short-Term Futures Index, and cash. This aims to provide positive returns in various market conditions but may not be perfectly correlated with the broader market.

Quotes:

• “Investors essentially get a much narrower band of potential outcomes with the end product.” (Morningstar)
• “The stated cap is the best possible outcome, but not a guaranteed return. This should factor into an investor’s calculation when comparing these ETFs against holding a CD or clipping bond coupons.” (Morningstar)
• “At launch, the stated cap rate and 100% downside protection are guaranteed. Defined results at launch help with planning.” (Calamos Investments)

Conclusion:

100% Downside Protection ETFs offer a unique value proposition for investors seeking absolute capital preservation within a defined period. Understanding the mechanics, benefits, and limitations is crucial for determining if these ETFs align with individual investment goals and risk tolerance. As these ETFs are relatively new, long-term performance data is limited, requiring further monitoring and evaluation.

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