Animal Spirits Podcast - Talk Your Book: Creating a Buffer

Episode Date: March 25, 2019

On today's talk your book we discuss surviving the upside when trying to hedge, the ideal client for hedging, structured product strategies in an ETF wrapper, why complex products require more homework, timing a hedging strategy, how options are impacted by volatility and much more. Find complete shownotes on our blogs... Ben Carlson’s A Wealth of Common Sense Michael Batnick’s The Irrelevant Investor Like us on Facebook And feel free to shoot us an email at [e-mail] with any feedback, questions, recommendations, or ideas for future topics of conversation. Learn more about your ad choices. Visit megaphone.fm/adchoices

Today's Animal Spirits Talk Your Book is presented by Innovator ETFs. Define Your Future. Go to Innovatoretoffs.com to learn more. Welcome to Animal Spirits, the podcast that takes a completely different look at markets and investing. Hosted by Michael Batnik and Ben Carlson, two guys who study the markets as a passion and invest for all the right reasons. Michael Batnick and Ben Carlson work for Ritt Holtz Wealth Management. All opinions expressed by Michael and Ben or any podcast guests are solely their own opinions and do not reflect the opinion of Ritthold's wealth management. This podcast is for informational purposes only and should not be relied upon for investment

decisions. Clients of Rithold's wealth management may maintain positions in the securities discussed in this podcast. Ben and I sat down with Bruce Bond, who is the co-founder and CEO of innovator capital management. Bruce has been in the ETF business for a long time. He is a co-founder of power shares back in 2003. So he definitely has had some success. in the past. And we were really excited to talk to him because a lot of the newish products are solutions looking for a problem. And this does not have that same feel to it. And one of the biggest problems a lot of people had in the aftermath of the financial crisis was, well, how do we hedge our downside? How do we get that downside volatility to come down? And unfortunately,

a lot of investors went into products that forgot about the upside. So they tried to hedge their downside too much. And then they forgot about, oh, wait. upside can be a risk too if we're not careful. And so people went into products besides just lowering the risk and going into bonds and cash. They went into things like hedge funds and manage futures and structured notes and all these other things that maybe they didn't know what they're getting themselves into. And they definitely have lagged on the upside probably in a much more meaningful way than they anticipated. So with that, we're going to get right into the conversation with Bruce and we'll see you on the other side.

We are sitting here with Bruce Bond, President and CEO of Innovator ETFs. Bruce, thank you so much for coming in today. Thanks for having me. So one of the problems with a lot of the products that are designed to protect the downside is that they can't survive the upside. So talk about these buffer ETFs that you've created that came out to market. How do they allow them to survive in a bull market? You know, the great thing about these products versus a lot of the other products that are out

there that promise to protect or buffer you toward the downside is that, you know, they have to have a switching mechanism or they have to have something market timing in there to allow for that. And it looks great on paper. But then when it really, when you're invested in it, it doesn't work out quite like that. The beauty of the defined outcome products is that you can look at them the day you invest and you can understand looking forward into the future. Okay, if the S&P 500 does this from this point, I'm going to get this on the upside and I'm going to have this amount of buffer on the downside. So investors. Hold on. How do you do? that. Well, how do we do that is with an options basket that is customized and it's using flex

options. And flex options are really just very simple. They're a custom option. And what they allow you to do is they allow you to have a specific start date and a specific end date for each of the options. There's about seven, eight options within each of the portfolios. And so they start on the same day and they finish on the same day or they expire on the same day. And then they will roll into a new set of options on that expiration date and it will continue for another year. So it's an optionist position that's set up that gives you a certain amount, really how it works is it gives you participation in the market one to one. And then we add in a buffer on the downside, you know, first protection.

And then, but there's a cost for that buffer. Well, in order to pay for that buffer, we have to sell something on the cap, which caps your upside in order to finance the buffer. And so that's how those two levels really come into play. So you have, the best way to think about it is you have a certain amount of options that give you the upside of the market, one to one on the market, and then you have another option that gives you the buffer. And then you have another, and in order to get that, you have to sell a cap on the upside

and cap your upside in order to get the downside buffer. So that's basically the idea of the portfolio and of the options package that are put together to do this for you. So who is the, when you created these, obviously there's different levels and there's different buffers in each of the products, and we can go through those in a little bit. But who's the ideal client or investor for these strategies? The way that we're trying to think about it is, so you have stocks and bonds kind of in a maybe barbell.

Is this position to be in the middle somewhere? Is that kind of the idea or is there a certain specific investor you're trying to target here? What's the ideal client for this? Well, I think what we're finding, the people that are attracted to it are really across the spectrum. You know, 75% of investable assets today are in pre-retirement and retirement hands right now. I mean, there's this huge glut of assets at the end of their, and they're getting ready to retire.

So they can't afford a substantial downtick in the market and recover. They don't have 20 years to recover. You know, they might have 10 or 15 years left on what they've got. And so they want to have something that they own that is going to provide them a buffer on the downside, but allow them to participate because they still need growth on the upside. So let me ask you a question. These traditionally speaking, the way to hedge is to just take less risk. If you don't want all the downside of stocks, typically you own more bonds or you hold more cash. Why is this a better solution than something like that?

The reason this is a much better solution than something like that is whenever you hold bonds or whenever you hold cash, what does that do to your overall position? It reduces it, right? Meaning you're expected returns. Yeah, you're expected returns to your portfolio as a whole. You take half your money, put it in cash and potentially in bonds. Well, that's going to cause a big drag on your equity return if you need to grow your portfolio. here from the moment you buy it, if you buy it at the beginning of the month, when the

funds, when the ETF is launched or when it resets, you're going to participate one to one on the upside, but you have the built-in buffer. And so it doesn't create this drag on your overall return like these other scenarios would. You know, that's why, you know, most managers in a mutual fund or in any fund really out there, they try to keep as little as they can in cash so that they aren't hampered by their overall performance relative to the market. So that's the beauty of these. You get the upside. Now, after you get there, you may hit a cap. You know, I mean, we don't think you will in a lot of circumstances, but you have the potential

of hitting a performance cap. But that's not until the top. It's not all the way up that you experience that. And you know what you're going to get before you participate. So the way that this is explained, in a lot of ways, it kind of sounds like some sort of structured products that we've heard up in the past and maybe insurance products. How is this different? And how is it similar? And then how are you able to create this in an ETF? structure and what are the sort of advantages of that versus a structured product that you get somewhere else? Yeah, the advantage is this versus a structured product first. Let's just talk about it from that standpoint. I think there's a lot of advisors in the marketplace that love the payout

of a structure product, but they're not really happy with the structure of a structure product. What do you buy the payout? Well, kind of the, you know, the promises that are made by the fun day one, you know, like you're going to get this. You know, they like the idea of a defined outcome, of understanding. Investors, by and large, they don't want to just hope that the market's going to go up. They like the idea of knowing what the potential outcomes will be, right? That's the reason structure products are popular for people. Well, so Warren Buffett said that you pay a high price for certainty in the market. How is this different than that? Well, you do pay a price. I wouldn't say a high price, but you pay a price for knowing what your return will be. And with these products,

what you give up in order to know that you have a buffer on the downside is you give up a little bit of side, which in some markets can be a challenge. But we'll talk about that a little bit because I think there's a way to improve your position as we get a little deeper into this. Right. So you have your three different buffer levels that you release each quarter. So what would be a way for, say, an advisor and investor to figure out what buffer level is right for me? And just before you answer, I just want to piggyback Ben's question. Do you envision the average investor logging onto your website, looking at the levels and then figure this out on their own?

or do you think it's usually going to be with the help of the advisor? We definitely think initially here it's going to be with the help of an advisor. We think these products specifically are a great way for advisors to bring value to their clients. We think they're fabulous products, but they're not just a plain vanilla product. They are pretty sophisticated, but I think as advisors look at the product and get to understand them, they're going to be really intrigued by the value that they can deliver to their clients. So we highly recommend that people use advisors for these because, you know, they are specific. and unique.

So can we talk about some of the different buffers and caps and how they work and where an investor should use them and think about them? Yeah, that's great. Back to Ben here. So we have three different levels of buffer that you can pick from. And really, I would tell people that maybe listen to the podcast, really the best way to think about these, you can get down the weeds and it can sound a little complicated, but really the best way to think about them is you're buying the SMP 500 with a buffer.

That's really the best way to think about it. there's three levels of buffer. There's a 9% buffer. There's a 15% buffer. Both of those start at zero and go down, right? And then there's a 30% buffer, and that starts at negative 5 and goes to 35. And so those are the three levels. If you're pretty bullish on the market, but you don't want to really take all the risk of the market, maybe you do the nine. If you're a little, you're bearish, you know, and you're like, it could go down. Maybe you do the 15. If you think everything's going to crash, then you want to buy the 30. So when you say the nine to 15. What you're saying is that if by the time that these products hit their expiration

date, if it's down 9%, you get 0% on the downside. Exactly. If it's down 20% and you have the 9 buffer, you're going to get a loss of what, 11%? 11%. Correctly. Yeah. And then on the big one, if it's down 50, let's say the market crashes 50% like it did in 08, you're eating 20% of that because of the first 5 and the last 15. Yeah, on the 30. Right. Right. On the 30, the way to think about it is if the market's down five, you're going to lose five because the buffer doesn't start until five. But if you're down 35, you're just down five. If it's down 40, then you're down 10%. You know, so these aren't, you know, they're pretty easy to figure out what you're going to get. So that, but that assumes that you buy it on day one and that you

hold it till the end of the period. Exactly. So let's say that you buy it on day one and you're using the nine. At the end of the period, if the market is down nine, you lose zero. Right. But let's say that intra period. Is that how you refer to it? Yeah, the intra period. So let's say intra period, the market is down 20%. Right. What would this, what would the nine look like? Well, so what it will look like is, I can't tell you exactly what it be, but generally what you would see is you would see, you know, the S&P 500 down 20. Yep. And this will probably be down in the, you know, eight or seven percent range, I would imagine is probably where you would be. So it's not going to be down nearly as much as the market, but it will be down. But it could pass its buffer

or intra-period. Right. It can go below the buffer, and so people want to be careful. You mean, if you buy it below the buffer, then you don't have a buffer left. You know, you're below the buffer and, you know, you can go down right with the market. Now, one thing I will say that's really interesting is that, you know, we had this scenario not too long ago, right, with the market when it adjusted. So there were actually people that were buying the power buffer, the middle one,

the 15 percenter, and let's say it's down maybe 7 percent in the buffer. So it's in the buffer 7 percent. Well, now you know, if the S&P. finishes anywhere within the buffer. So if it goes back up to zero or if it goes down at all, if it finishes anywhere in that 15%, they're going to make 7%. Because, right, the ETF is going to go back to zero. So they have upside. And so they're saying, hey, I'm just going to take that as kind of a fixed income return to what people think about. Yeah. Right. So they know what their upside is. And they're like, if the market goes down, I have another, you know, 7% protection

on the downside. But, you know, I don't really think the market's going to go up. So I'm just going to take that. Now, how do they, how do they know that? they can go into your website and see this. Yes, exactly. I would recommend anyone that's listening to this that has interest in it. Definitely on the interim basis, you're going to want to go to the website and check it out. It's a fabulous tool. Just go to the product you think you're interested. Go down. Look, there's a chart there. It shows the S&P and then it shows the fund and where the fund is trading relative to its starting point in the SMP. There's a table there as well. Now, you can drag on the tool and it will show you exactly what if you bought that day at that price, this is what

return methodology would look like. You know, this is like your investment profile looks like. This is what your upside cap is. This is what your downside buffer is. And so you can know. And it also tells you, okay, you have this much more time left, you know, before this happens. You know, if you're buying halfway through, you don't have a whole year. You only have six months left to realize that return. Do you think it matters? Obviously, it looks like you guys roll out these funds on a quarterly basis. The next one being in April, would it be your preference that investors simply get in on these funds pretty much on day one or zero and sort of buy and hold them? Or do you think that there are going to be more sophisticated investors that do get in there

and get into the weeds and try to figure out ways to sort of time this? Yeah, I think there's, you know, we're seeing both, but we're definitely seeing people get in in the middle. Let me give you just kind of an anecdotal think about this. So we brought the 9% in January, right? The B-JAN is the symbol for that. Okay, and the market's up big from there. I think it's up 12%.

Well, B. Jan is up about 10%. So now you own B Jan. You're a couple months into it. You're up 10%. Your buffer is way down there now. You know, it's below you. But in April, we're bringing out a new B Jan. Well, if you look at that, you would be able to roll out of there into the April,

B April, right? Lock in your gain and you're going to get a better cap than you currently have. And so you're able to step up that return. Expand your cap and also lock in. in your game. So that makes a lot of sense. And maybe it sounds like these do have to be sort of actively matched because to your point, if your cap is 2% away and your buffer is, you know, 18% or whatever it is, you might as well go into it. You might as well do it. Exactly. And it allows you to improve your position. It's not like you have to do that, but the beauty of these products is that

you can do that. So we're trying to think of ourselves on the wealth management advisor side trying to explain us to clients. And the way that I tried to put this as it's bond-like in some ways because because you almost have a, it almost gets back to par value or something. Ben said this is, these are risk-free returns. Yeah, right. Yeah, that might be a little stretch, but, you know. But in, in some ways, it almost sounds kind of like a bond ladder in certain ways. Am I looking at that the wrong way? Is that? I think you're looking at it's similar. You know, one of the ways that we try to explain it,

and it isn't this exactly, but if you think about it, you know, a little bit like a new bond, right? I mean, you knew a, if you buy a new bond on day one at par, you know what your coupon is, you know what your yield is and you know it's going to mature a year from now, let's say. Well, if you buy it in the middle, all of a sudden, you know, the bond's moving around. You're really buying it based on yield at that point. That's when you want to go to the website and see, well, where is it trading relative to its coupon and to its par value. So it's really similar to that for people to think about it when they want to try to relate.

Now, the only thing is that your maturity, you know, your $1,000 maturity is moving around a little with the SMP, which changes the dynamics, you know, because you don't really know where it's going to finish. But the chart kind of helps you understand what your potential outcomes will be. So to that point, how come there are buffer levels of 9% for three different products for B-Juel, B-Oct, and B-JAN, but the caps are different? Okay, that's a great question. The reason the caps are different is because the market, depending on what the market is doing,

there's a thing within the options market is called skew, which is kind of a comparison between what calls are priced at and what puts are priced at. And the more the skew is off, the higher the cap goes. The skew tends to get off if you think about it. If you have a lot of volatility and people are trying to go long or they're trying to go short, the skew moves. So the interesting thing about these particular products is when the market is really volatile or makes a big turn, the cap tends to go up. Whereas if you think most insurance products or type of products to try to protect you, they kind of pull in the protection when those kind of things happen or the buffers or when those things happen because there's more risk in the market. here the exact opposite happens. So for example, the July products when they came out, the caps were probably like roughly in the 10% range. And when the October came out, the 9% was like in the 15% range. And then in January, you know, when the market crashed late October, December there, you know, we had a 22% cap on the B jam. And so the caps tend to really expand based on the volatility in the market.

So the higher the volatility, the higher your caps. Higher the volatility, the higher the cap. Tends to be. There's a lot of factors that go into it, but that tends to be accurate. So sticking with the options theme, obviously sometimes option trading strategies for the lay investor can be difficult to understand. How do you explain the way the options work and maybe compare and contrast with something like a put selling strategy, something like that that may be? Yeah, I think it's really a very simple approach to putting the options together.

You know, there's a there's a boxing combo, they call it, which is a, it's just an option box, really, that produces the return of the SMP. 500 and it also simultaneously takes the dividend yield out of the SMP 500 with that yield so it upfronts the yield and then you use that yield to buy your buffer now sometimes you don't have quite enough yield coming out of the S&Ps let's say it's at one and three quarters or something you don't have enough to get the buffer you need and that's when you have to sell to get enough off the cap in order to get more to finance the buffer to put the buffer in and where the cap lands if you think about where the cap lands, you know, the further the cap up, the less you get, the further

cap down, the more you get, and then so the more you can finance it. And that's, it helps you understand a little bit more how the screw in the market would affect it. Is there any risk that this will not work in the sense that it won't do what it says it's going to do? Or is this purely a matter of math and it is going to work? There are no guarantees, you know, in our business, you know that? We're not an insurance company, unfortunately. But I would say that this option's position is built. It will expire on a given day at a given price. and we know where it's going. So there's no, in terms of risk like the nightmare scenario with XIV, where investors

didn't read the prospectus. Yeah, there's nothing like that that exists in these particular products. Okay. And the other thing that I would say is really interesting about these products. You know, once the, think about it like a tech portfolio in an ETF and that running for the year. And then you just buy the same tech stocks every year. The same thing here, you're, we're setting this with specific, you know, seven or eight

options positions, and we just buy those same positions through the year. and the positions go up and down a value, just like a stock would do, but they all produce the same outcome at the end. And that's the reason it's possible. Well, sticking with that theme of a different way of looking at this in terms of tech stocks, is there any thought of running this in a different index? So obviously the S&P has probably got to be the most liquid, cheapest to trade, all that stuff in terms of options. Are the thoughts on your end to roll this out in other indexes and other platforms? Yeah, I mean, I can't see a lot about it right now, but I will tell you that recent-

link once if yeah right right exactly so but we we do have a registration statement that is public that has been filed on the mscii efa the mscii emerging market as well as on the russell 2000 and on the what we're calling tech 100 right now until we get some other licensing we can read between the lines yeah right exactly any final thoughts no i think that's it i i would just really encourage advisors to take a look at these i think you know i've been around the industry for a long time and have introduced a lot of different products to the market. And this is really an intriguing opportunity for ways for advisors to bring additional value to the table for their clients in a way that they haven't seen before. And that's why we're so excited about it.

Very good. Thank you so much. Thank you. Thanks for having me. Okay, we want to thank Bruce again for meeting us in Chicago and sitting down with us. I will say this is probably one of the interviews we've had to put the most preparation in for because when we first started looking at these products, at first glance, it seems relatively easy and the more you dig into it, the more complex it gets. And I think we got into that a little bit in our discussion. But it started hurting our head a little bit, thinking about all the variations here.

And I think Bruce did a good job of explaining how it can work in terms of buying on the very first day, the ETF comes in to play or understanding the dynamics of in between the period and what to do depending on where you are in the buffer. So getting back to what we said in the beginning of the show about a lot of the products that are designed to protect you from the downside can't survive the upside. And one of the problems especially is that a lot of them are either opaque or illiquid and complicated. And this is about as simple as a complicated product can get. But we would urge everybody to really, really do their homework. And we'll put this in the show notes, a link to the site where you can see where the buffer and caps are in real time, because

it's been mentioned, the buffer and caps are set on the effective date when these things launch, sort of like a bond. It's at par. You have your yield. You know exactly what you're getting. But once it starts trading, things can change a little bit. So we mentioned that the price can go below the buffer intra period. So really, again, just know exactly what this product does before you go out and buy it. And it's definitely not, even though this trades S&P 500 index options, this is definitely not your typical passively managed product. It's obviously an active strategy, but you can also get active within the strategy,

as we discussed. So I think that makes sense to, these are called defined outcomes ETFs. I think it makes sense to define what you're looking for when you go into something like this and whether you are going to buy the date comes. So the next listing is April 1st. That will be one of the new BAPR. is the one that that is called comes out. I think you better understand whether you're trying to do this in sort of a buy and hold to expiration or am I actually going to get in there and try to

be more tactical with these hedging strategies like Bruce discussed. So I think you have to define what you're looking for. You and I tend to be very skeptical of things like this, but I think that we were both pretty intrigued. And certainly like on the business side, I am very bullish on this product raising a lot of assets. Yeah. And I think, especially on the advisor side of the equation, advisors could push this type of thing as, like you said, a solution to a problem people are looking for. Because the way that they've marketed this in terms of naming them defined outcome ETFs, I think that's a really good way to describe it. And I think people will latch onto that in a lot of ways. It just depends on whether you can understand what they actually do. And so, again,

there's three different levels. We talked about it a little bit in the interview, but they have a 9% buffer level, which would technically mean by expiration, you shouldn't eat any of the first 9% in downside of the S&P 500. Now, of course, if the- Assuming that you bought it on day one. Right. And yes, if you bought it on day one, if you bought it in between, you're going to have to look it up and see what the current caps are and the current

buffers are. But that could also mean if the S&P rises 5%, in the meantime, before it goes down to that 9% threshold, you could still see a 14% drawdown from the high. So it really makes sense to understand when you're getting in here. So in the same thing with a 15% you're covered on that. And then the 30% is interesting because you're not covered on the first 5% of a loss, but you are covered up to 35% from a 5% drawdown. So my example to him was if stocks fell 50%, you're protected and 30% of that.

So you see a 20% loss. So this is not exactly a new idea, but it's certainly maybe an old idea in a new, much more efficient wrapper. So this used to exist in structure notes, which exposes the investor to counterparty risk, typically high fees, illiquidity, and if you want to get out early, perhaps a penalty to get your money back. And we saw a lot of these come across our desk at the endowment fund I work for post-crisis because people wanted to understand that they had some, again, that downside protection. And the problem was when that upside cap was hit, they missed out on a ton of gains because

those structured notes were much more illiquid. So I think the fact that you can do this inside of an ETF wrapper is great. And another reason that ETFs, I think, are really democratizing investing for people. It's taking these strategies that were once sort of opaque. And again, this one is still could be kind of hard to understand if you really get into the weeds of it. But again, the idea is that you have this range of outcomes that you're kind of guaranteed on either side. You kind of know what you're getting yourself into. The fact that it's in an ETF structure and liquid is really good for.

people I think that want to explore this. With stocks, you have a very wide range of expected outcomes. In any given 12-month period, you could expect stocks to be up as much as 30% or down as much as 30% and even more in some cases. And what this really does is it just squeezes the range of expected outcomes to a place where people can get comfortable. So if investors are looking to put this in their portfolio, where could you see it? We asked Bruce about that. Is it something that's in between stocks and bonds, like an alternative? Is it a piece of the stock market exposure if someone gets in their allocation? You know, that's a good question. I think that you could bucket this really in a number of ways. So I'm not sure that I have a great answer. It has

stock and bond like characteristics. True. Yeah, which I think is why I know a lot of advisors come to us asking about alternatives and Liquid Alt, and I know people have tried a bunch of different strategies in the past. They want that middle ground, especially since rates were so low for so long. that maybe bonds weren't going to cut it for a lot of people. And I think this is an interesting thing to explore for a lot of people that maybe want to not see the huge range of outcomes. You know what's also nice about this is that this is not an after-the-fact product. Right.

Where I feel like in 2009 and 2010, we saw a ton of black swan-like strategies hit the market. Right. This is, like you said, trying to solve a problem that people have in terms of people are worried that the S&P 500 is overvalued, and they frankly have been worried about that for a long time now, call it seven or eight years, I think. But this is something that you can do that sort of dips your toe in the water and gives you at least the chance to have some upside and protect your downside, depending on what your thresholds are going to be. Right. Outside of holding more cash or more bonds, this seems like a fairly sensible way to hedge your portfolio. Yes, again, given the fact that

you understand what you're getting yourself into. And so honestly, I think the biggest risk for people and something like this is not paying attention to it and seeing maybe that upside risk where it's above their upside cap and they're missing out on gains because they weren't paying attention. Or I guess for some people, just understanding that if your gains are capped and you're okay with that, with the fact that you have that downside hedge, just understanding that you know what you're getting yourself into. That's right. Anyway, thanks again for Bruce and innovative ETFs are coming on and explaining this. We'll have some links in the show notes to all their different frequently asked questions

and some of their different series and we'll put some pictures in the show notes, two of the charts that they used that they kind of walked us through. And again, we think we'd love to hear some feedback from people on their thoughts on this one and see if they have any questions or concerns, potential risks, because we think it's an interesting thing to do your homework on and maybe potentially take a look at. So anyway, send us an email, Animal Spearspot at gmail.com, and we'll talk you later. You know what I'm going to be.