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Voices: These ETFs save investors a trip to the casino

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ETFs are looking for a few good gamblers.

ETFs are famous for tracking simple, broadly diversified indexes cheaply, transparently and tax efficiently, an ideal combination for long-term investors. The problem for aspiring issuers is that the market for those ETFs is dominated by the big three — BlackRock, Vanguard, and State Street — which collectively manage 82% of ETF assets, according to Bloomberg Intelligence. To stand out, smaller firms are turning to more complex and niche funds.

Enter Innovator Capital Management, which is expected to introduce its S&P 500 Buffer ETF on Aug. 15, the third in a trilogy. The S&P 500 Power Buffer ETF and the S&P 500 Ultra Buffer ETF launched last week. The funds shield “investors” from a one-year decline of up to 9%, 15% and 30%, respectively, in the S&P 500 Price Return Index in exchange for a cap on the index’s return.

All of this may sound straightforward, but it’s far from it. Consider the Power Buffer ETF, for example. The gambit crucially depends on an “outcome period,” which runs from July 1 to June 30 and renews every year. Investors in the fund for an entire outcome period can expect a gain of up to roughly 8% if the index is up, or a loss for any decline in the index greater than 15%. To be sure, these upside caps are changed each year. And as the market declines, the caps tend to expand. For instance, in 2009, they reached as high as 22%, and averaged just over 11.5% over the past 12 years, based on CBOE data.

Buy the fund on any day other than July 1, however, and those expectations might be irrelevant. Here’s why: If the index is down in the intervening period, investors receive less protection — or none if the index has already declined more than 15% — and must wait for the index to recoup its losses before seeing any gains. Inversely, if the index is up since the period began, investors stand to make less — or nothing if the index is up more than 8% — and must wait for the index to revert to its July 1 level to receive any protection. (Innovator plans to issue defined outcome ETFs quarterly in July, October, January and April) so investors can lock in targeted returns even if the market moves up or down significantly during any given year.)

Some funds that were in the black still turned in a poor performance — it’s all relative.
July 24

What’s lost in all the complication is that this is no place for long-term investors. For one thing, the price return index excludes dividends, which is a big drag on performance over time. The S&P 500 Index has returned 9.9% annually from 1928 through July, including dividends, while the price return index has returned just 5.8%.

Also, the odds don’t favor investors. Remember that they win if the index’s return lands somewhere between a negative 15% and a positive 8% during the year. But the index’s historical return and volatility since 1928 imply that the return will fall within that range just 40% of the time.

That, too, is a drag over time. There have been 90 one-year periods ending on June 30 since 1928. The index rose more than 8% in 45 of those years and declined more than 15% 14 times. In other words, investors would have won just one-third of the time over those nine decades. And their reward would have been a return of 2.9% a year from July 1928 to June 2018, or half of the index’s return of 5.7%.

The way to win, of course, is by correctly predicting the index’s return over the next year. I’m not aware of any reliable way to do that, but I suspect there will be no shortage of investors armed with their models and overconfidence bias ready to play.

It won’t be cheap. The funds take 0.79% of each annual bet. That’s less than the fees charged by banks and insurance companies for similar products, but far higher than the ETF industry’s asset-weighted average expense ratio of 0.21% a year, according to Morningstar data.

None of this means that ETFs shouldn’t allow investors to speculate on the market. But if ETFs ever aspired to distance themselves from the casino mentality that has long plagued wide swaths of the mutual fund industry, those ambitions are increasingly fading away.

Bloomberg News