Why Defined-Outcome Products are Dominating ETF Flows
Bruce Bond is co-founder and CEO of Innovator Capital Management. Having cofounded PowerShares Capital Management in 2003, he is recognized as one of the pioneers of the ETF industry. His leadership, creativity and entrepreneurial vision challenged the conventional thinking about ETFs and blazed a trail that made way for the massive growth of what is known today as smart or strategic beta. In addition to being recognized for best-in- class products, Bruce has been named the ETF industry’s most influential person on multiple occasions. He is a thought leader and has been quoted in financial publications around the globe. Innovator Capital Management was named as the industries ETF Issuer of the Year in 2019 by ETF.com.
I spoke with Bruce on June 1.
Why did Innovator launch defined-outcome ETFs?
I actually think it’s vice versa--Defined Outcome ETFs in a sense, launched Innovator. These products are the reason we exist as a company, and it was the reason I came back into the ETF industry.
Post-PowerShares, I still kept a close eye on the ETF market. It was evident the marketplace was becoming extremely proliferated. Over the last two decades ETF issuers had chopped the market into literally thousands of pieces. Today, there are more ETFs than equity securities listed on the exchanges. I didn't see a lot of opportunity left to innovate within the current construct. And the idea of coming back to fight over a small percentage of ETF assets amongst 100 other ETF issuers was not all that appealing to me.
The one thought that always bothered me though, was that most of the ETFs out there left everyone “naked in the market.” Millions of people invest in the equity markets through ETFs, but they are generally exposed to the full risk (and reward) of the market. This downside risk has always just been an accepted reality of investing in the stock market, and folks would use bonds to reduce their risk (and to generate income). Given today’s low rate environment, as millions of baby boomers enter retirement, they can no longer rely on the fixed income markets for income or for risk management, nor can they rely on volatile equity markets in order to turn growth into income. The same is true for any person or institution with a risk management goal, or a spending mandate, like a defined benefit plan.
We worked through several iterations of potential solutions to this problem, and once we felt like we landed on something the market could benefit from we decided to re-enter the market. We’re not trying to conquer the world, or destroy the competition. We’re here to lead, to innovate, and to pioneer new solutions that really serve the needs of investors today, in a way they never thought possible. I think Defined Outcome ETFs deliver on this promise well.
How were you involved with QQQ, the ETF that tracks the Nasdaq 100 index? How does that relate to defined-outcome ETFs?
That’s a question with a lot of history behind it. The first ETFs were initially created by exchanges in an effort to increase trading volume at the exchanges. I don’t think any of them foresaw quite how successful that effort would turn out to be. The first ETF—State Street’s SPDR S&P 500 Trust was introduced in 1993 by the American Stock Exchange, and the Nasdaq 100 ETF was Nasdaq’s version. QQQ became known as the place to go to for exposure to technology stocks. Throughout the tech boom and for a few years after, QQQ was not only the most actively traded ETF in the world, but was also the most actively traded security in the world.
Unlike SPDR, which was marketed and distributed by State Street, QQQ was issued, and lightly marketed by Nasdaq. In my mind, they were missing the “State Street” part. I thought the Qs could benefit from an ETF issuer focusing on the sales and marketing of the product. In October 2006 we announced that PowerShares was acquiring the Nasdaq-100 Index Tracking ETF from Nasdaq. That deal quadrupled PowerShares assets overnight (adding $19b to our existing $7.62b) and really helped build the PowerShares brand into a household name. We were in a better position to compete head-to-head with iShares, State Street and Vanguard as a result.
QQQ is nearly 30 years old. It’s still one of the largest ETFs in the world, with approximately $100b in assets. One difference I see now versus then is that several of the tech companies that were born on the Nasdaq are now much more mature and stable.
Today the Nasdaq 100 is still a bellwether for people looking for technology exposure. It’s one reason we think it makes a lot of sense for Innovator to provide a defined outcome ETF with a 15% buffer on the Nasdaq 100. People like technology exposure, but it often comes with increased volatility. A buffered approach to owning the Nasdaq 100 allows people to participate in the upside (to a cap), with a built-in buffer; and in fact, that upside participation potential will be higher if the product launches when volatility is heightened.
When did you start thinking about expanding your suite to other major indices and what led you to do that?
We began issuing the world’s first defined outcome ETFs in August 2018, beginning with the S&P 500, knowing that the S&P 500 is a core holding in many people's portfolios. Our initial plans were to expand to other liquid markets (e.g., Nasdaq 100) once we completed the quarterly series of the S&P 500 products, but market demand led us to expand into those other indexes more quickly. We ended up offering monthly exposures to the S&P 500, and introduced a 15% buffer on the Nasdaq 100 about a year later, in October 2019.
The Nasdaq 100 was one of the first exposures that we looked to add because there is so much interest in the tech space. Getting exposure to the Nasdaq 100 with a buffer may help lower the downside risk associated with that space. Financial advisors were seeking ways to mitigate the amount of risk they're taking. To date, we have three quarterly issues of the Nasdaq 100 Buffer ETFs launched (January, April, and October). While this is one of our smaller lineups in terms of number of products, the lineup has the second most assets (behind the buffered S&P 500 exposures).
You talked about the fact that the Nasdaq 100 gives you exposure to technology. What is compelling about the Nasdaq 100 index to make it a portion of a client's portfolio?
The Nasdaq 100 holds the 100 largest, non-financial stocks listed on the Nasdaq. It's interesting primarily as a tech allocation, or as an innovative-company allocation in these markets. Most new, tech-type and cutting-edge companies are listed on the Nasdaq. People often want exposure to these young, new, innovative, disruptive companies in a diversified fashion. I think the Nasdaq 100 offers a great way to do that.
How do you see advisors implementing these defined-outcome ETFs in their client portfolios?
Specifically, for investors with have large-cap exposure through SPY or any S&P 500 product, we see people moving those assets into the Innovator S&P 500 Buffered ETFs. For investors that may have heavy tech exposure within a mutual fund or an individual security, we see some of those assets rolling into the Innovator Nasdaq 100 PowerBuffer ETFs, reducing their downside risk to tech, but still participating to a degree.
More broadly, we have three very basic ways that advisors are using defined outcome ETFs. Advisors are taking a portion, and some honestly have taken all of their equity exposure and moved that into the buffer ETFs. Many of them have moved over and said, "Okay, I'm going to buy a buffer for my equity exposure right now. I don't want to risk any more downside. The recession may be coming after this pandemic, and I don't want expose my clients to any more downside.”
The beauty is that you get one-to-one exposure to the upside of the markets, and you have a built in buffer against the downside. That is the key. Yes, you have a cap, but in my opinion, two of the most innovative things about these products are the liquidity and price transparency—the ability to buy and sell a defined outcome, at a known price, any time the market is open. You're always able to roll out of your current Defined Outcome ETF into a new one, essentially locking in your potential gains, and getting a fresh cap and buffer in the new ETF.
We're seeing people take outright equity exposure and move it over into the buffer ETFs, or take half of their equity exposure and move it into the buffer ETFs.
The other thing we're seeing advisors do is using Defined Outcome ETFs as a fixed income replacement. Yields on fixed income are at all-time lows. Many advisors don’t feel there is much upside left unless rates go negative, and they aren’t willing to stick around for that. So they are moving to buffered ETFs.
Lastly, the simplest place that we see people use it is to replace their alternatives sleeve. If you were buying some kind of hedged ETF, or something that employs a risk management strategy that isn’t well understood, they are moving to something with a little more certainty, which the buffer ETFs seek to provide.
Those are the three core uses: De-risking equity exposure, replacing fixed income exposure, and replacing alternatives exposure.
Given the current economic backdrop, why are your ETFs so relevant?
The Nasdaq 100 Index headed towards a new all-time high, all while the global economy has gone through a tremendous shock. There are tens of millions of people out of work. A lot of companies still can't open. There's just such an incredible amount of risk embedded in this market; more so than normal. From my perspective, staying invested in the market, but with a built-in buffer makes a lot of sense right now.
It's like my dad always told me, “A bird in the hand is worth two in the bush.” The bird in the hand is that buffer. The two in the bush is what's going to happen. Could I get a little bit more, or could I not? Most people would just take a bird in the hand, knowing that they have a built-in buffer, knowing what their outcome will be, rather than just being naked in the market and hoping for the best.
And Bob, another very important point I want to make is, if you look at most risk management strategies in existence today, they have in a sense, “done what they are supposed to do.” But that doesn’t always equate to good outcomes for people. Many risk management strategies de-risk during volatile markets, moving to cash. This takes them out of the market. Look at 3/24-25. Folks using more traditional risk management strategies missed 18% gains because they were sitting on the sidelines!
Defined outcome ETFs don’t operate this way. Defined Outcome ETFs seek to provide investors with the upside of an equity market (e.g., Nasdaq 100) to a cap, with a built-in downside buffer, over an outcome period. They are invested in the market, all the time, with a hedge that is always in place. The cost of that hedge is a capped upside participation. But the beauty of it is the upside cap is typically higher when markets are volatile, which allows people to actually participate more fully in market upside exactly when they need it most.
With our Buffered products, the day you buy it, you're able to evaluate what you're buying, and understand what your potential outcome will be at the end of the outcome period (e.g., one year). There are no moving parts, there's no switching back and forth. There’s no moving to cash. You own the same securities throughout the entire period, and you know that you have a certain amount of buffer and a certain amount of upside available to you.
Now if you start to get “capped out,” if the market runs up well beyond the cap level, you can always roll into a new month, and you can make tactical adjustments. The ability to actually know what your potential outcome is provides a lot of comfort for people. It eliminates emotion, because fear is what typically drives selling behavior, and Buffer ETFs help take fear out of the equation. They cast light on your future outcome potential.
With other, more active approaches, they basically work until they don’t. It's the same thing for correlation within a diversified portfolio. At some point most asset classes become highly correlated and fall together. We've seen this happen a couple times historically. So that is the big difference between these particular styles of investing.
Defined outcome investing stands in such stark contrast to other risk management approaches that I wanted to spend some time pointing out the differences.
Tell me about what products you're thinking about for the future.
In addition to the next quarterly series of Innovator Nasdaq 100 Buffer ETF that is scheduled to launch at the beginning of July, we are very excited about bringing three additional potential product offerings to market:
- “BUFF” is the ticker for a new ETF we plan on bringing out. It is an ETF of ETFs, tracking an index. The Index is composed of 12 Innovator S&P 500 Power Buffer ETFs. The Index is designed to ladder the 12 Innovator S&P 500 Power Buffer ETFs to provide upside to U.S. equities (subject to caps) while buffering against the first 15% of U.S. equity losses. Each of the 12 ETFs in the Index is assigned an equal weight and will rebalance on a semi-annual basis. The nice thing about it is you don't have to worry about trying to get in at the beginning of an outcome period, or decide when to get out. This ETF diversifies you across the entire product range of 15% buffers, offering what we believe will be a very smooth ride.
- STACKERS: This is a term we’ve coined for a new Defined Outcome ETF line that gives an investor the opportunity to gain “Stacked” upside additive exposures to multiple indexes (e.g., S&P 500, Nasdaq 100, and Russell 2000) to a cap, with the downside exposure of only a single market (e.g., downside exposure of just the S&P 500). We really think this is an attractive proposition if an investor holds a moderately bullish viewpoint over the next one-year period. By utilizing an Innovator “Stacker ETF”, one could experience additional gains beyond a moderate growth year in the S&P 500. While there is an opportunity for additional gains beyond simply holding the S&P 500, the downside risk is limited to the losses of only the S&P 500. We’re a planning a couple versions of this out of the gate—one with a buffer, and one without a buffer on the downside.
- Defined Outcome Fixed Income: The third new category we’re introducing is defined outcomes on Fixed Income asset classes. The first iteration of this will likely be a 5% floor on the iShares 20+ Long Term Treasury ETF (TLT), where investors are exposed to the first 5% of losses in TLT over the outcome period, but none thereafter. In other words, investors can potentially avoid 95% of the downside risk of TLT over the outcome period.
Rates are extremely low. With this particular Defined Outcome ETF, if rates go negative and the price of TLT increases, you participate in that increase to a cap. If rates go higher, and the price of TLT goes lower, the most you're going to lose over the next year is 5% (before fees and expenses). We’re also planning an ETF that delivers a 9% buffer on TLT. We think these are going to be extremely powerful tools for asset allocators.
We believe these will be ideal for advisors building portfolios with stock/bond allocations. A lot of people are fearful to go out in duration that far because of how volatile the price swings can be. This ETF helps address that concern by cutting off the downside tail risk. You get 1 to 1 on the upside to a cap, and you have 5% downside risk. That's going to be very attractive.
The Funds have characteristics unlike many other traditional investment products and may not be suitable for all investors. For more information regarding whether an investment in the Fund is right for you, please see "Investor Suitability" in the prospectus.
Investing involves risks. Loss of principal is possible. The Funds face numerous market trading risks, including active markets risk, authorized participation concentration risk, buffered loss risk, cap change risk, capped upside return risk, correlation risk, liquidity risk, management risk, market maker risk, market risk, non-diversification risk, operation risk, options risk, trading issues risk, upside participation risk and valuation risk. For a detail list of fund risks see the prospectus.
Technology Sector Risk Companies in the technology sector are often smaller and can be characterized by relatively higher volatility in price performance when compared to other economic sectors. They can face intense competition which may have an adverse effect on profit margins.
Fixed Income Risk Income securities are subject to interest rate risk and credit risk. Interest rate risk is the potential that a change in overall interest rates will reduce the value of a bond or other fixed-rate investment. Credit risk is the possibility of a loss resulting from a borrower's failure to repay a loan or meet contractual obligations.
FLEX Options Risk The Fund will utilize FLEX Options issued and guaranteed for settlement by the Options Clearing Corporation (OCC). In the unlikely event that the OCC becomes insolvent or is otherwise unable to meet its settlement obligations, the Fund could suffer significant losses. Additionally, FLEX Options may be less liquid than standard options. In a less liquid market for the FLEX Options, the Fund may have difficulty closing out certain FLEX Options positions at desired times and prices. The values of FLEX Options do not increase or decrease at the same rate as the reference asset and may vary due to factors other than the price of reference asset.
These Funds are designed to provide point-to-point exposure to the price return of the Index via a basket of Flex Options. As a result, the ETFs are not expected to move directly in line with the Index during the interim period.
Investors purchasing shares after an outcome period has begun may experience very different results than funds' investment objective. Initial outcome periods are approximately 1-year beginning on the funds’ inception date. Following the initial outcome period, each subsequent outcome period will begin on the first day of the month the fund was incepted. After the conclusion of an outcome period, another will begin.
Fund shareholders are subject to an upside return cap (the "Cap") that represents the maximum percentage return an investor can achieve from an investment in the funds’ for the Outcome Period, before fees and expenses. If the Outcome Period has begun and the Fund has increased in value to a level near to the Cap, an investor purchasing at that price has little or no ability to achieve gains but remains vulnerable to downside risks. Additionally, the Cap may rise or fall from one Outcome Period to the next. The Cap, and the Fund’s position relative to it, should be considered before investing in the Fund. The Funds' website, www.innovatoretfs.com, provides important Fund information as well information relating to the potential outcomes of an investment in a Fund on a daily basis.
The Funds only seek to provide shareholders that hold shares for the entire Outcome Period with their respective buffer level against Index losses during the Outcome Period. You will bear all Index losses exceeding 9, 15 or 30%. Depending upon market conditions at the time of purchase, a shareholder that purchases shares after the Outcome Period has begun may also lose their entire investment. For instance, if the Outcome Period has begun and the Fund has decreased in value beyond the pre-determined buffer, an investor purchasing shares at that price may not benefit from the buffer. Similarly, if the Outcome Period has begun and the Fund has increased in value, an investor purchasing shares at that price may not benefit from the buffer until the Fund’s value has decreased to its value at the commencement of the Outcome Period. STACKERS & FIXED INCOME ETFS: INFORMATION CONTAINED HEREIN IS SUBJECT TO COMPLETION OR AMENDMENT. A REGISTRATION STATEMENT RELATING TO THESE SECURITIES HAS BEEN FILED WITH THE SECURITIES AND EXCHANGE COMMISSION BUT HAS NOT YET BECOME EFFECTIVE. THESE SECURITIES MAY NOT BE SOLD NOR MAY OFFERS TO BUY BE ACCEPTED PRIOR TO THE TIME THE REGISTRATION STATEMENT BECOMES EFFECTIVE. THIS COMMUNICATION SHALL NOT CONSTITUTE AN OFFER TO BUY OR THE SOLICITATION OF AN OFFER TO BUY NOR SHALL THERE BE ANY SALE OF THESE SECURITIES IN ANY STATE IN WHICH SUCH OFFER, SOLICITATION OR SALE WOULD BE UNLAWFUL PRIOR TO REGISTRATION OR QUALIFICATION UNDER SECURITIES LAWS OF ANY SUCH STATE.
AN INDICATION OF INTEREST IN RESPONSE TO THIS ADVERTISEMENT WILL INVOLVE NO OBLIGATION OR COMMITMENT OF ANY KIND. BUFF: In July, 2020, the Innovator Lunt Low Vol/High Beta Tactical ETF (LVHB) will undergo several important changes, including a replacement of the underlying index, investment objective and strategy, a change to the Fund name and ticker, and a reduction in the Fund’s total annual operating expense ratio.
The Funds' investment objectives, risks, charges and expenses should be considered carefully before investing. The prospectus contains this and other important information, and it may be obtained at innovatoretfs.com. Read it carefully before investing.
Innovator ETFs are distributed by Foreside Fund Services, LLC.