A New Class of ETFs Creates New Opportunities to Manage Risk
Defined outcome ETFs provide exposure to the price return of a broad equity market (like the S&P 500) and typically offer some level of upside participation, often capped, as well as a specified level of downside protection.
Investors today face ongoing uncertainties that can make engaging in the markets unnerving. And while traditional ETFs go hand-in-hand with market fluctuations, a new type, defined outcome ETFs, seek to manage that volatility. These funds help you gain or maintain a level of market exposure, often while providing partial protection from downside risk with built-in buffers, over a defined period.
Defined outcome ETFs share some common traits with traditional ETF vehicles. They offer:
However, unlike traditional ETFs, defined outcome ETFs are constructed using a combination of call and put options, which are guaranteed for settlement by the Options Clearing Corporation–it is this combination of options which creates the investment’s upside potential and downside protection features.
Did You Know? Defined outcome ETFs are also sometimes referred to as target outcome ETFs or structured ETFs. A buffer ETF refers to one of the most popular types of defined outcome ETFs. Over a defined outcome period, it provides buffered protection against market declines in exchange for upside potential that is capped.
A Growing Menu of Offerings
Defined outcome ETFs are quickly earning a place in investment portfolios as versatile solutions that provide varying levels of exposure to a variety of markets (like U.S. or international equity indices). They can be used both actively and passively.
- In a passive approach, defined outcome ETFs can allow investors to obtain risk-managed exposure to the market without the need to periodically rebalance and reinvest.
- In an active approach, defined outcome ETFs may enable investors to capture market opportunities as they become available.
Each fund has four key terms that determine its payout profile:
- Underlier: Defined outcome ETFs provide a return based on the performance of an underlying asset (which could be an index or a fund).
- Outcome Period: The length of time over which the investment seeks to achieve its defined outcome. Typically, this period is one year long.
- Upside Feature: The return potential over the full outcome period. Typically, defined outcome ETFs participate in the positive performance of the underlier, up to a defined cap.
- Downside Protection: A form of protection that absorbs a fixed percentage of the underlier's decline after which the investor may, and often does, participate in the decline in the underlier.
Downside protection can come in different forms, but the two most common are:
Here is an illustration of how a hypothetical buffer ETF with the following terms would perform in different market scenarios, assuming you bought it at the beginning of the outcome period and held it to the end of the outcome period.
For illustrative purposes only. The diagram above is intended only to show mathematical outcomes based on specific assumptions. It does not and cannot represent forecasts, predictions or even estimates of actual future outcomes, which will vary according to a range of inputs, factors and impacts (known and unknown) that cannot be accounted for by the diagram. The above diagram is based on the hypothetical price performance of the underlier over a 1-year outcome period, excludes any dividends, and assumes an investor remains invested in the buffer ETF for the entirety of the outcome period. The diagram does not represent all market scenarios and does not include the fund’s management fees and costs associated with purchasing the shares.
One important aspect of defined outcome ETFs involves when you purchase them. While the funds are offered during an initial offering period with fixed cap and buffer levels, they can also be bought intra-period, or once the defined outcome period has already begun. In that case you would receive different terms than if you purchased at the beginning of the outcome period.
Investors should understand the differences between the fund’s initial metrics and remaining metrics (described below), as the fund’s results will vary depending on the timing of your investment. Furthermore, trading an ETF in the open market occurs at the fund’s current market value, which can be a premium or a discount to its net asset value (“NAV”).
- The fund’s initial metrics, including the initial upside cap and buffer levels, are calculated at the beginning of the outcome period based on the initial price of the fund.
- The fund’s remaining metrics are calculated throughout the outcome period based on fund’s market price, which is a function of the value of the underlying options contracts.
Who Might Consider Defined Outcome ETFs?
Because defined outcome ETFs are mainly designed to remove some of the uncertainty associated with investing, they may fit a wide range of investor risk-return profiles. They also provide risk-averse investors the opportunity to maintain a degree of exposure to equities.
Defined outcome ETFs have countless applications. Here are some scenarios for potential use and key benefits and considerations:
- Exposure to the growth of the market, tailored to your risk tolerance and outlook
- Evergreen investment removes the need to periodically rebalance and reinvest
- Transparent price on an exchange
- No corporate credit risk
- Defined outcome ETFs may be subject to significant market risk. Losses are possible if the underlier decline exceeds the buffer.
- The initial buffer and cap will only be realized if you purchase the fund at the beginning of the outcome period and hold it to the end of outcome period.
- At the end of each outcome period, the sponsor will reset the terms based on current market levels; the new cap may be more or less favorable than the prior outcome period’s cap but the buffer remains the same, as originally stated in the prospectus.
- Investors purchasing shares after an outcome period has begun may experience very different results than fund's investment objective because the terms of a given defined outcome ETF are fixed for the duration of an outcome period.
- A defined outcome ETF will not move directly in line with its underlier, because it includes one or more option contracts. The fund market price may differ from the fund’s NAV, which is determined by the value of the underlying components, especially during times of market volatility.
If you are a financial professional and your firm provides access to SIMON, you can view and filter the latest defined outcome ETFs available to you in the marketplace on simonmarkets.com or learn more about them in our Learning Center. If you do not have access to simonmarkets.com and would like to learn more, connect with our team by emailing us at firstname.lastname@example.org to request a demo with one of our Platform Specialists.
Defined outcome ETFs are considered complex and may not be suitable for all investors. An investor should consider investment objectives, risks, and charges and expenses of a defined outcome ETF carefully before investing. The prospectus and, if available, summary prospectus, contains this and other information about a defined outcome ETF, are available from the Fund or Fund sponsor at the sponsor’s website, and should be read carefully before investing.
1 Fund upside and protection terms reset upon conclusion of an outcome period; the new cap may be more or less favorable than the prior outcome period’s cap.
Defined outcome ETFs are considered complex and may not be suitable for all investors. An investor should consider investment objectives, risks, and charges and expenses of a defined outcome ETF carefully before investing. The prospectus and, if available, summary prospectus, contains this and other information about a defined outcome ETF, are available from the fund or fund sponsor at the sponsor’s website, and should be read carefully before investing.
This is not intended to be an offer or solicitation to purchase or sell any security or to employ a specific investment strategy. This material is intended as general background information, for educational purposes only, and this material should not be used as a primary basis to make an investment decision. The materials provide a general overview of the products described, and actual financial instruments may differ materially from those described. No person should consider investing in an instrument on the basis of these materials. Any investment decision should be made only after carefully reviewing the applicable prospectus. Please remember that all instruments described in this material involve a risk of loss. This does not constitute legal, accounting or tax advice, and the recipient should consult with his or her legal, accounting or tax adviser regarding the instruments described in this material.
An investment in a defined outcome ETF is subject to risks and an investor can lose money on an investment in a defined outcome ETFs. Select risks include:
- Capped upside return
- Downside buffer cannot protect against all losses
- During an outcome period, a fund may not move directly in line with the underlier
- Payoff profiles established upon inception date and options contract roll dates of the fund. Investors purchasing shares between these dates may experience very different results, may experience losses without benefit of a buffer, and may be subject to a cap on all or most gains
- All investments subject to market risk
- Dividends of the underlier are not paid to the investor
- No guarantee strategy will achieve its objectives, generate profits or avoid loss
- Options and concentrated strategies magnify risk
- Newly organized funds subject to volatility of inflows and outflows
- Share prices may differ from net asset value
For more detailed information about the risks associated with a particular fund and for more information on investor suitability, please see the prospectus.