Innovator Capital Management’s suite of Defined Outcome Series exchanged-traded funds are built to give equity investors a defined downside while offering some participation in rallies, and financial advisors and other investors looking to manage risk in a late-stage economy are plowing money into these products. Since the initial launch of these products last August, the series has grown to $917 million in total assets under management. The funds are designed to follow the S&P 500 Index’s price return with some downside protection from losses, but with a cap on gains.
The Defined Outcome Series includes the Innovator S&P Buffer ETF, which has a 9 percent downside buffer; Innovator S&P 500 Power Buffer ETF, which has a 15 percent buffer; and Innovator S&P 500 Ultra Buffer, which has a 30 percent buffer. The Ultra Buffer is designed to mitigate against a fall of 30 percent over the outcome period, from negative 5 percent to negative 35 percent. That means investors will exposed to a loss between 0 percent and 5 percent, and over 35 percent, during the outcome period.
Within each ETF are a series of months—June, April, January, October and July, with each month having its own ticker symbol. For example, the series with the greatest AUM is the October S&P 500 Power Buffer ETF (POCT), at $190 million. It resets in October 2019. All of these funds have an expense ratio of 0.79 percent.
The series uses options spreads to mitigate downside risk in the S&P 500, but also cap upside potential over a set time period, usually one year. If purchased on the first day the ETF is available, a fund like BAPR, which is the April S&P 500 Buffer ETF, protects buyers from the first 9 percent of losses after each April reset. If the market falls more than 9 percent, the fund will track the losses.
Investors who don’t buy on the first day will have an outcome different than those who bought on the first day, as the fund will move up and down with the market, says Bruce Bond, CEO of Innovator Capital Management. The firm has a tool on its website that shows what an investor’s payoff will be from the day he or she purchased the ETF.
The portfolio holdings are FLEX Options with different strike prices (a strike price is where the option holder may buy or sell the security by a specified expiration date) but the same expiration date of roughly one year. FLEX Options are customizable exchange-traded option contracts guaranteed for settlement by the Options Clearing Corporation.
Innovator says these options are why the ETFs can mitigate losses to a certain extent. So how did they do during the fourth-quarter sell off?
Bond points to the actions of the POCT fund, which debuted on October 1, 2018, as an example. POCT’s upside cap is 10 percent, and its downside buffer is 15 percent. At the depth of the S&P 500 drawdown on Dec. 24, the S&P 500 index fell 19.2 percent, but POCT was down 9.6 percent, mitigating almost 10 percentage points of the losses for a person who bought the ETF on its debut.
There was another reason to buy a fund like POCT during that downturn, Bond says. While the fund had only slightly more than a 5 percentage point downside buffer left, the upside cap was 19.6 percentage points. If the S&P 500 finishes anywhere in the buffer zone when POCT resets in October, the ETF would float back to its beginning level, giving the investor at least a 9.6 percent gain from the low, in addition to possibly capturing an additional 10 percent if the market rebounded.
Bond explains that the funds work much like buying a one-year bond in the secondary market. The face value of the bond may be $1,000, but the investor may pay a premium or discount which will affect the rate the buyer receives. Because the ETF buys options, there’s the time value built into the option which decays as the expiration nears. “They don’t move around a whole lot right at the beginning, but toward the end the time value has come out of the market so they’ll more closely track the market toward the end,” he says.