ETF Edge - “Buffered” funds & volatility 8/14/24

Episode Date: August 14, 2024

We put last week’s volatility spike into historical perspective. Plus, we discuss the option of employing so-call “buffered” funds that provide downside protection… but at a price.    Hosted by Simplecast, an AdsWizz company. See pcm.adswizz.com for information about our collection and use of personal data for advertising.

The ETF Edge podcast is sponsored by InvescoQQQ. Let's rethink possibility. Investco Distributors, Inc. And welcome to ETF Edge, your go-to place for everything. Exchange, traded funds. I am your host, Bob Pizzani. Can ETFs protect against a drop in the markets? August has been a volatile month for stocks.

A large cohort of older investors has created a demand for products that allow investors to still stay invested but provide some protection on the downside. Now, how does this exactly work? Let's talk with Bruce Bond. He's the CEO of Innovator ETFs. Also joining us, Mark Hagan, Senior Vice President at Index Fund Advisors, and author of the book, Investing in U.S. financial history,

understanding the past to forecast the future. Bruce, these buffered ETFs are supposed to provide partial downside protection while still staying in the markets. There's a new one every month. I want you to explain how they work, but what kind of buffer, for example, does the August power buffer provide? Explain what we're particularly?

here and what the buffer is like. Yeah, happy to do it, Bob. So the August power buffer gave you 15% protection on the downside. So from 0 to negative 15% over a year, and you get 12.8% of the upside over that same period. So if someone wants to invest in the S&P 500, they can get right in and do that. They have 15% protection on the downside, and they have 12.8% opportunity on the upside. side. So for August, I want to just repeat this because it's a it's a little hard to figure out. The maximum upside, if you bought August first with this, the August buffer, the maximum upside you get

next year is 12.8% on the S&P 500. Above that, you don't get any more. And you're protected up to a drop of 15% in the S&P 500. If it drops more than that, you can still, if it drops 16% you, you're still liable for that extra 1%. That's how it works. Right. Right. So, right. So, for this one. Yeah, if it went down 20, you would lose 5%. But that is the buffer, the 15%. So it's, it's a level of protection. That's the reason we call it a buffer instead of just protection. You know, it protects you for a certain amount of downside in the market. Usually within the realm of what people are comfortable with. I just want to get through this. There's one for the start of every month. So the August buffer ETF is meant to be held for a year.

It's an ETF, so you can buy any time, but the prices may change. And what happens at the end of the year? Like, if I buy August 1, what happens at the end of the year? At the end of the year, the reason we tell you to wait an end of year because there are one-year options within the portfolio. So at the end of the year, the options are fully valued. And then we reset it for a following year. So next August, they would fully value.

Then we would reset it for another year. You would get another 15% downside buffer. So you couldn't lose for the first 15%. And then you'll get a cap. Now, the level of your cap depends on where the market's at at that time. So the cap, you know, historically, over the last couple of years has been higher than where we are today at 12.8%. But it could, so it could be higher. It could be a little bit lower.

But it all depends on the amount of volatility, dividend yields and those types of things in the marketplace. So for those who want a little more detailed, this involves buying and selling options. There's actually four that you're buying and selling here. You're holding an S&P 500 option for the target month. Then you're executing a put strategy. You're buying a put option with a higher strike price. You're selling a put option with a lower strike price. Then you're selling an upside call option to finance the downside protection.

This is a lot of options activity. I just want to make it. Some people are actually interested in how this works. So these are the details on it. So there's essentially four executions here that you that you're four options executions here, right? Yeah, that's exactly right, Bob. And we we buy one option gives you a participation in the market and then there's a put spread. That's a 15% and then we sell a call at on the upside at the level we have to to raise some additional money to pay for the put spread.

That's how the package gets to go right put together. It's basically a zero sum package, right? It pays for itself. then somebody can just invest that. We do it at the institutional level, so it'd be very difficult for a retail investor to ever duplicate the cost of it that we do it at. Okay, Mark, I wanna bring you in here.

Your book, Investing in US Financial History, it's a fascinating book, a very comprehensive look at US financial history, including Act of Management. What do you think of this, what do you think just generic of strategies that allow investors to yeah I mean my concern with that my question would be the use case I mean I'll take it at your

word that that it actually works it is pretty complex but there it seems to be hedging volatility in my guess is an expensive way and this is going to sound kind of simple but it's true that one of the big problems with investors particularly long-term investors is they get spooked in the short term and a cheaper way to hedge against getting spooked in the short term is just not look at your portfolio. There's a great quote from Richard Thaler, who's a behavioral finance expert. He said, the more often investor counts his money or looks at the value of their mutual funds in the newspaper, this is an old quote, the lower their risk tolerance. And my concern with a solution like this, and again, I don't know all the use cases here, but my concern

would be a lot of investors are creating a very expensive solution for what is ultimately a simple problem, which is they need to be more comfortable with the normal volatility of markets. And speaking to financial history, that's a way that financial history can develop, can give you that confidence in disruptive markets. When you've seen enough of these repetitions, you kind of know, you don't know what's going to happen, but you know it will resolve itself. And if you're a long-term investor, short-term volatility, really shouldn't be concerned sometimes it can be helpful in terms of rebalancing. So it's really the use case. And my guess would be there are people using these types of funds that could find a cheaper

solution to deal with that volatility. Bruce, Mark's bringing up a point about the cost of the options. Options are expensive. The fee for this ETF is almost 80 basis points a year, 0.8% a year. What do you say to that? Is his point here is there may be. a cheaper option out there to do either nothing or even rebalance and lower your exposure a bit. You know what? I think for somebody that researches the markets, I think that tends to make sense. But for people that are actually putting their money at risk, it doesn't make any sense. If what Mark said is true, we should all go out and just buy Navidia today because we believe it's going to do well in the long run, or even the S&P, or even the NASDAQ, or even the NASDAQ, or even

And you know what? I think, you know, 95, almost, almost $100 billion was sold in annuities last year. Now, why does that happen? The reason that happens is because people are fearful of losing their money. 75% of the assets that are investable today are in people's hands, 55 plus. they do not have time or want or and they're just not willing to have their money go you know drop by 20 30 percent and then hope it comes back in time and they might have to get another job type of things when you actually put your money on the line and it's not just theoretical it's very difficult to do and so a lot of people they like having some knowledge of the potential outcome long term so that they know, okay, I can put my money in. I mean, look how much money

is in, you know, six, seven trillion dollars in money markets today. As people just, you know, they're just fearful of the market. And most people do not want to take on the full brunt of the market. And the fact is, bonds haven't saved you. They haven't protected you. And by sticking your head in the sand and just saying, well, I'm just going to pretend it. know, I'm going to be okay. People just are not comfortable with that most of the time with real money. They just, you know, I've seen it. You know, I believe me, I've had hundreds of equity products, hundreds of fixed income products, and I can just tell you this fits a group of people that are interested in getting exposure to the market, but not taking the full risk of the market.

Okay. Mark, what do you say to that? I mean, there is a point there is, I mean, annuities actually are a form of downside protection. people do give up potential upside and having other things out there in exchange for a stream of income. So there is evidence people are. Annuities is evidence that people are exactly concerned about that. Yeah, I mean, honestly, I think that this is the job of a financial advisor. And it's funny. The reason I wrote this book was when COVID hit, I admittedly was kind of caught flatfooted. I'd never seen anything like this before.

But the more I started reading about financial history, the more I realized, that nothing over the last four years was unprecedented. And I think the role of a financial, you know, a financial advisor who is providing value is to calm people during times like this. And, you know, just over the past week, that's what, what I've been doing is it seemed like it was a flash crash last week, which is not unprecedented. It was actually a pretty plain, vanilla and benign one as far as flash crashes go. And I just, I think financial advisors that are doing their job can provide the calm at, or the, you know, the calming advice at a lower cost than products like these. And, you know, that's not a judgment about whether these products work

or not. I just, you know, I think there are cheaper solutions out there. Yeah. Bruce, I want to move on here. You have other buffered products that offer even more protection, 100% downside protection that are also monthly. Let's take the case of one of them, the equity defined protection ETF for August. The symbol is Z-A-U-G, Z as in Zebra, A-U-G. Tell us how this works. Well, I mean, these are very similar to people that buy like a CD, a bank CD or a market-link CD. Basically, what you can do is you can buy Z-Og and hold it for 12 months. And over that 12 months, as long as you bought it, you know, right up front, you're not going to lose money, but you have access to a certain amount of the upside in the market.

That upside in the market, you know, is around 9%. And so you get the upside of what's available in the market that the options market, kind of the ball market they call it, will give to you, which you have no risk of loss. And so people that currently are in a money market and rates look like, you know, they will probably go down in a money market. And remember, a money market, you have to pay tax on money market. So even if it's at 5%, you're going to get dropped a little bit after taxes. Here you have the potential to get 8.8% over the year, no risk of loss.

And the other thing that's important here is that you have a safe asset that's in equities rather than fixed income. And so you're getting the potential upside that's available for equities up to a cap with no risk of market loss. There are, you know, as we mentioned a bit ago, you know, billions and billions and billions of dollars that are put into these types of protective strategies because people don't want to take on the full risk of the market. And that's why these, and I think what we've done is we've looked at those and we've said, okay, a market link CD, very expensive, structured products, very expensive, annuities, very expensive. these take what they do, put them in an ETIP. They give you transparency. They give you liquidity. They give you no counterparty risk like these other products have.

And they're completely liquid. You can buy and sell them at any time. So they've improved significantly these other products in the market that, you know, billions of dollars are being put into. Well, I have to say that in terms of annuities, we, we, 30 years of, ago at CNBC there was a whole discussion about annuities and they were very popular but they generally were products that were sold and not bought so you it was 5% commission was very typical and 80 basis points against a 5% commission is certainly a better deal I you know and I would

certainly grant you that and in an ETF wrapper which is more transparent is also these are definitely improvements these products are definitely improved over just simply, you know, buying a annuity and giving way 5% quite up to a or structure product or, you know, any of these other type of products, you know, very expensive. And so to get this type of an outcome for people to control their exposure, there's nothing like that available in the market today. And so this is where they need to come for that type of protection. Yeah.

Yeah. Mark, I want to get your perspective on what's been going on in August. We're talking about protection against volatility. the market has been very volatile in August. How did you react to the big drop on August 5th? You're a financial advisor. There's money under management. I went for a walk on the beach.

Your company. Well, you know, and that report on August 5th, by the way, the events of August 5th followed that disappointing July jobs report, and there was a big run up in the end that day. I know some said it was a mini flash crash. How should we view what happened? You referenced it briefly, But how should we view what happened?

Yeah, I mean, it struck me at the time as a flash crash. And it was actually a pretty small one. I mean, if you go back to October 19th, 1987, I mean, it dropped, I think it was about 22% in a single day. But, you know, I write about this in the book. Flash crashes are kind of like the rogue waves of Wall Street. It happens when you have a bunch of different market forces kind of coming together at the same time. That's what happened in 1987. And I'm not going to, there are a bunch of complex forces, economic and technical as well with portfolio insurance.

But they all converge at the same time and you get these outsized movements in the market. And the one that occurred on August 5th just, it seemed like that. So you had the activities in Japan with with the Bank of Japan raising rates and the collapse of the Japanese stock market. You also had in the United States a it wasn't a horrible, but a relatively weak employment report. coupled with the triggering of kind of the latest fadish metric, the SOM rule. So you had all these forces colliding. It created an outsized movement. And you never know how deep it's going to go.

You never know how long it's going to last. But you are better off doing nothing in these events. And now if your portfolio is out of balance, there could be an opportunity to rebalance and actually generate value. But it just seemed like a rogue wave. And you get these, you get these periodically. And you just got to keep your wits about you. So I just want you to summarize this.

What's the best reaction to volatility? What does investing history tell you investors should do? It seems like you're saying, by and large, if you have a plan and a long-term investment claim, you should do nothing in reaction to a sudden flash crash. It seems that's correct. And possibly rebalance. You know, if you have a portfolio and you breach certain limits, it's actually a great opportunity to rebalance. There's actually a great story about David Swenson, who's very well recognized as one of the best institutional investors ever.

He was the late CIO at the Yale University Endowment. And he used to actually trade on days like this. He had a little trading desk where he would trade treasuries and rebalance the portfolio. So if anything, it's an opportunity. I'm not saying people should do that. But at minimum, just the worst thing you can do is, trade out of fear and sell risk assets when you have one of these crashes. They do resolve eventually.

You can't predict when, but you're just better off doing nothing. Better. So the bottom line here is have a plan and stick to it, whether you're buying protection or you're buying buffered products or you're staying with the S&P 500, stick with the plan. Don't do anything in a panicky way. Very interesting discussion, folks. We've been talking about volatility and how to handle volatility. And here are two experts.

in the field with slightly different approaches to it, but still very important for you to understand the history of markets and how they've reacted to these sudden big moves here. Thanks, everybody, for joining us. That does it for this week's ETF Edge. My thanks to Bruce and Mark. We've asked Mark to stick around and provide us additional insights into what financial history can tell us about the markets today. That's coming up in the ETF Edge podcast. And remember, you can see all of our shows on our website, etfedge.c.c.com. Everybody have a healthy. happy and safe trading week. Get the ABCs of ETFs with the ETF Edge newsletter.

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