ETF Edge - Protecting Against Downside: Buffer ETF Boom 4/10/23

Episode Date: April 10, 2023

CNBC’s Bob Pisani spoke with Graham Day, CIO of Innovator ETFs – along with Todd Sohn, ETF and Technical Strategist at Strategas Securities, a Baird company. As investors look to navigate the choppy market landscape in the new month, the gang delved into so-called “buffer ETFs"– or ETFs specifically designed to cushion the blow against downside in the broader markets, while also capping potential gains. It’s become an increasingly popular strategy and they broke it all down with the man who helps run Innovator ETFs, a pioneer in the buffered products business. In the “Markets 102” portion, Bob continued the conversation with Todd Sohn from Strategas Securities. 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 InvescoQQQQ, supporting the innovators changing the world. Investco Distributors, Inc. Welcome to ETF Edge, the podcast. If you're looking to learn the latest insights on all things, exchange traded funds, you are in the right place. Every week we're bringing you interviews, market analysis, and breaking down what it means for investors. I'm your host, Bob Pisani. As investors look to navigate the choppy market landscape, today on the show, we'll delve into so-called buffer ETFs. ETFs specifically designed to cushion the blow against the downside while also having potential gains.

It's become an increasingly popular strategy. We'll break down what it all means with the man who runs innovator ETFs. They're a pioneer in that buffered products business. Here's my conversation with Graham Day, the CIO of innovator ETFs along with Todd Sone. He's the ETF and technical strategist, a strategist, a strategist, securities. That's a Baird company. Grab these products that allow investors to stay in the market but provide downside protection. They were big hits last year.

But I want to, we got to educate the viewers about this. Just briefly explain how these buffered products work. Yeah, it's a great question, Bob. And really at the heart of these products, you get equity exposure. And in exchange for an upside cap, you receive a known level built-in buffer to hedge against downside losses. That's really it. You're trading unlimited upside in exchange for that known level of built-in buffers against loss. And again, with equities dropping in 2022, bonds dropping in 2022, it's all about risk management today. That's what these products offer.

And we just put up a screen, PNOV, this is one of the, one of the buffer products. They protect against the first 15% of losses. There are, other ones that you provide that are out there. But what happens the first 15%? You have no loss up to that. And what happens after that? So very simple, like you said, Bob, downside buffer of 15% against the first 15% of losses. If the market were to drop 16% over a one year period, you'd be buffered against the first 15% of losses and then take on that last 1% of downside. So market's down 16, you'd be down 1% with the power buffer ETS. Okay, now we're going to talk about some other variations on this, but I want to bring you in,

Todd. These products, they work great in an up market, or excuse me, in a down market or a sideways market, but you do give up some upside here if you're in an up market. So this is not some kind of like magic bullet protection against virtually everything. Of course, there's risks with any investment, and these, if the market were to, go on a tear here, a 2021, a 2017, 2013 type year. You're going to lose it on the upside. Now, the counter to that, though, would be if you think about the last five years when these product launched, we had a 20% correction for Q2018. We had the COVID crash, and then we had last year which you were down some 20% at one point. That has been a fantastic environment for

the buffer DTS and why they exist. So I get the idea that you may miss the upside, but if you're close to retirement, if you're a novice investor that may be scared of getting into the markets, given what's going on these last few years, these are a decent starting point, despite them using options, which may be a little bit confusing. It makes absolute sense to me if you're an older investor and you still want to stay in the market. You don't want to throw your money into cash or bonds or something like that. You want to stay in, but you're getting close to retirement or you're in retirement and you want some protection. These products make a lot of sense. And look at the money coming in. There's been some very successful products in this.

in the space. J.P. Morgan's JEPI. On fire. $23 billion in assets. That's a huge ETF that's out there. So you have low volatility stocks with that that overlay covered call options, essentially. I see BlackRock. We mentioned last week BlackRock

is getting into this buffer ETF game. They just filed for two buffer defined outcome ETFs, aiming to cushion against the downside while also capping potential gains. So this is in the Maybe BlackRock's a little late to the party, but...

I think BlackRock filing for these ads, credence to the category, right? You're talking about the biggest issue we're stepping in, right? That's more competition for innovator, but it definitely lends a hand to saying this is for real. And then, you know, the other part of it, I think covered call, buffer ETS, you can make the case that this is the new innovation, right? Innovation was the hot product a few years ago. Everyone filed, followed Kathy Wood and her team. And now you're seeing covered call type strategies, option-related strategies to get that income through the equity market now. Graham, maybe we can have a little bit more about the products that you offer.

So I had Bruce Bond on last year talking about the BALT, the innovator defined wealth shield, which tracks of return the S&P 500 to a cap. Explain that to us briefly. There's a little bit of a bewildering variety of choices here that you're introducing to investors. Explain how this one works, the BALT. Well, Bob, our goal is to provide and equip advisors with an array of two. tools that can help them achieve their clients, you know, return and risk objectives. Balt is a little different than our typical buffer ETS.

Bolt provides an approximate 20% buffer every three months against the equity markets and has the upside potential attached to that as well. And what we've seen is because every time the market has corrected, the 20% buffer of Bolt has really guarded investors against losses. And then when the market has had some upside recovery, investors have been able to participate in those gains. And so what we've had since we launched this product about two years ago is Balt has actually generated positive total returns

despite the equity markets falling over that same timeframe. So Balt is our most conservative to find outcome ETF. and it also has the shortened outcome period, and we find advisors using this as an easy way to tiptoll into the defined outcome space. Yeah, now you've got a new product that's launched last week, the barrier ETF. So you've got this barrier etep product line. This one seeks to provide high income and a barrier against losses over a certain time period. Explain how these products work because they just came out last week, right?

That's right. That's right. So we're really excited about these products, Bob, because what we've sought to do here at Innovator since 2017 is to bring payoffs and payoff structures that have only been available in structured notes or insurance wrappers. We think bringing them in the ETF wrapper has a tremendous amount of value add for advisors and their clients. And so what barrier ETS do is they're very similar to buffer ETS.

you have a known level of income that would be distributed over a one-year outcome period, and you also have known levels of risk management that are also built into the product. And so you can see here, 10, 20, 30, and 40 percent barriers against losses to the equity markets. It's a way for investors to diversify their income streams, take some credit risk off the table, take some interest rate risk off the table. 2022 is ugly for bonds, advisors, investors. They're looking for ways to diversify.

So let me put up one of these. Put up APRJ for me. I believe that's the 10% product. So here, the market APRJ, the symbol here, the market, there it is. We'd have to go down, no, that's the 30. I'm sorry, but APRJ, you get the point.

The market would have to go down 30% to lose anything, but it pays an income over the year in quarterly payments. Is that correct? That's right. So APRJ has an income distribution rate around 7.5%. And so you're right, Bob, if the market does not fall below that 30% barrier thresholds over next one year, if the equity market don't fall more than 30%, you would essentially receive your principal at the end of the outcome period and the quarterly coupon payments. And so the equity market, and so the equity market, These are different. They don't need the equity markets to have positive returns in order for you to generate positive returns. If the market breaches that barrier, then you are down in line with the market.

But the key is you will always receive those quarterly distribution payments. And again, borrowing from what we've done in the structured note world. Right. I want to want you to explain the difference here between the barrier and the buffer products, because you just said something important there. On that 30 year we just put up and on the 10 year, if you drop more than 10%, if you drop 11% on the 10% product, you then breach that, right?

You're down 11%. So in the buffer products, it's different, right? It's important for people to understand what you're getting here. That's right. And Bob, it's all about the amount of risk that you're willing to take. And so with the buffers, if you were down, if the market was down 11%, then a buffer investment would be down just 1%. If you had a 10% buffer, with the barriers, you're buffered or you're protected against the

first 10% of losses, but then if the market falls below that barrier, you're down 11%. But you still get the distribution rate. So if the distribution rate was 10% with the barrier, then on a total return basis, you'd only be down 1%. But again, buffers have more protection in place than barriers. And so you do not get the same levels of income that you can with the barriers. Barriers are what we have seen in the structured note space for a long period of time. It's what advisors are used to seeing. That's what we're doing is bringing it and making it available in the ETF wrapper.

I'm thank you for making the distinction there between the two, but it's a little bewildering the variety of offerings here. How are you seeing advisors use these products right now? What are they doing with these products? Yeah, so we just launched them, Bob, but what we're seeing is advisors that have maybe used structured notes in the past and yield-focused notes and using these ETS because the ETS wrapper streamlines the operational efficiencies in their practice.

It removes credit risk. There's daily liquidity that long. of benefits that the ETF wrapper provides. But again, it's looking at what happened in 2022. And income is very important for advisors, but so is risk management. And when you have investment-grade corporate bonds losing 18, 19 percent on a total return basis in 2022, advisors are realizing that bonds aren't the safe haven that many thought they would be. And so if you can pair these with the fixed income, we think that that offers a tremendous amount of diversification benefits. You know, Todd, it's everything you're saying makes sense, but it's kind of a bewildering amount of products and confusing and hard to explain to people.

Definitely. What do you give advice out to clients on the ETFs? That's your job. What do you tell people about these kinds of products? I think the end. It makes sense, right? It's defined. People like the brand name defined outcome, right? That makes sense.

But an innovator, I think, does a great job on their website of explaining you need to make sure that you are involved on the first day of the reset, whether it's January, April, May, whatever it might be. And then also, you know, don't get too scared of the word option. I know the pros know what's going on here, but if you're a novice investor, understand that they're not doing anything too crazy, right? If that was the case, I don't think these products are gathering assets. it's too much. And now what I also think is really interesting from their product set,

you have it on the S&P, but they have also released MSCIEF, MSCIEM, small caps, and Aztec 100. So you're getting a great product set from Innovator. And I'd be curious as ETFs continue to grow and the options markets on other funds deepens if they'll add more sweets out there. Yeah. Well, the answer is if the money comes in, they will. Graham, I know these buffered ETFs have gathered assets, and congratulations on the success of them, but they are difficult to understand. No, regulators have voiced some alarm over these kinds of complex ETFs. That's a word Gary Gensler used.

In May of last year, Gensler, who's the chairman of the SEC, warned that, and I'm quoting from him here, these complex ETFs could pose risks even to sophisticated investors. and can potentially create system-wide risks by operating in unanticipated ways when markets experience volatility or stress conditions is is there any validity to these concerns how do you respond to those comments and again this was done may of last year

well bob when we talk to advisors and and illustrate how the e p. s are constructed they're actually taken aback by how simple the construction is with the buffer e-tieth-feree s we're holding a portfolio of four to five options on the S&P 500 ETF, on the NASF 100 ETF. And once those options are bought, the portfolio is fixed for the remainder of the outcome period. We are not touching any of the options.

That's what gives the defined outcome for investors. And so we think it's somewhat ironic that these products, which we've had in the market for five years, they've delivered exactly what they said they were going to do. and when you look at the down markets, the buffer ETS have done what they should. They've buffered investors against downside losses. These are risk management tools. These aren't trading tools. These are for advisors to put in a strategic allocation, whether it's on the equity side,

whether they're underweight fixed income. They can use these products in that sleeve as well. And so, again, yes, they're options. And you can dig into them if you want, but at the end of the day, These are very simple. Basket of four or five options. They're set for the entirety of outcome period. We don't actively manage the portfolio at all.

Yeah. You know, I have differences of opinion with Gary Gensler, but there have been concerns voiced about complex products. And I don't just mean buffered products or define outcome, but leverage at inverse ETFs, for example. Do any of these, should there be any regulation? There are some people who will argue that these kinds of complex ETFs should actually be separate.

from plain vanilla ETFs, for example, because of potential risks around them. Are there potential risks? Does this make any sense? Or is Gensler just sort of going overboard on this? I don't necessarily think overboard, but I do believe some of these products need better labeling, whether that's due brokerage sites or whatnot, just understand that if you're buying a leveraged product, it resets every day. And so just because the S&B goes up 30 in one year, it doesn't mean you're going to get triple bad return.

they are more expensive. If they're an ETN, they can be taxed differently. So I do believe something needs to be done rather than calling ETFs that you'd find an avant-garde phone. The average viewer cannot wrap their head around the daily reset. I mean, it literally makes your head explode when you try to explain a daily reset to people. Wait a minute, I'm not getting three times inverse oil.

ETF is not, if I hold it for a month, they don't get three times. It depends on what's happening on a daily basis. And that is- It literally makes their head explode. Yeah, that's exactly why something so complex I think does need a layer of additional scrutiny. Yeah. I want to ask you, you do something a little unusual.

You provide ETF research to institutions. This guy is one of the few that does this out here. Why isn't it more traditional institutional research for ETFs? I mean, everyone is obsessed with macro research, but nobody's covering ETFs. And strategists, you're one of the few ones that are actually in that space. This was the idea behind why we wanted to produce this content for our clients. And I think it's maybe a historical bias. We've been so used to macro research and single stock research.

It buys as hell's hold on all these securities that are out there. And ETFs have kind of just been there on the side as looked at as passive investments, cheap, transparent, what not. And I don't think they've gotten the love that they should, given how important they are now as building blocks for the investment community. The other argument could be made that there's simply too many that do the same thing. I know we talked about dividend ETFs. But isn't that an opportunity for an institutional advisor to explain that and say, here's what we're telling people to use and why? Absolutely.

It seems obvious. The products, the opportunity here is to look at all the products are out there and have similar labels and understand what the ingredients are in each of those funds. I think that's where the opportunity is. I have made it very clear my unhappiness with the analyst community. I think the quality of cell-side research has been going steadily down for 20 years. And it's very alarming because there are companies that desperately, small-cap companies, that desperately need coverage, don't have it.

And we need more. And yet we can't figure out a way to pay analysts. Europe has basically eliminated soft dollars, can't pay them. We don't know how to pay them anymore. And so there's more need. There's less quality and higher need. And there seems an obvious gap here, and I don't know how to fill that gap. It's very frustrating for me.

That's something we're trying to solve, too. I know that some of our clients do appreciate the ETF work because they're part of their core portfolios and their client's portfolios. And there are others who still like to play single stocks. And that can continue to go on. Graham, well, what's in the future here? Money's still coming in. At least I see money coming in. You've just launched this whole new line here.

What else exists out there in the world of defined outcome ETS? Well, I think we're just getting started. Bob. Again, this is a space that's been dominated by the structured note and the insurance world and making it available in the ETF wrapper for the first time. Back in 2008, now we have the first income-focused defined outcome ETF. And so we think we're just getting started. We're in the early innings of the opportunity here. And again, this is the environment where investors are wary of bonds. Is the Fed going to keep hiking? They're worried about equity markets continuing to decline. The buffer ETS are in that sweet spot.

PAPR gives you 15% of the upside to the market, a 15% downside buffer. Not a lot of advisors we're talking with think the market's going to go up more than 15. They're still cautious, but they want to stay invested. They don't want to time the market. All right. I appreciate the help. And a very interesting discussion. Thank you for joining us.

Now it's time to round out the conversation with some analysis and perspective to help you better understand ETFs. This is the Markets 102 portion of the podcast. We continue in the conversation with Todd Sone from Stategis Securities. That is a Baird company. Todd, I just want to talk about the inflows this year because it's been a little unusual. We have sluggish, I think, is the way to define it. We've had outflows from U.S. equities, but we've had some significant inflows into international equities. We've had outflows from corporate and high yield funds, but we've had huge investments.

flows into treasuries. Overall, flows are a little lower than last year. Make sense of this all for us. What does this mean? So for U.S., I blow it down to this is what happens when you raise rates 500 basis points in a year. That is a huge change that we've been used to. And I think that has left investors, very skittish, as he say, perhaps nervous. And where do we go from here? Is the Fed done hiking, perhaps? Are we going into a recession? Maybe, maybe not. I think that you're being reflected in the flow is there. And then the other part of this, leading international, leading into international, valuations have always been attractive there. And you also don't have the concentration

risk that's brewing again within US equities. Apple and Microsoft are 13% of the index. The top five names are almost a quarter of the index again back like in 2021. So I think there's some comfort with international. You get a little bit more diversification, a little less tech if you're concerned about that. and maybe a little bit more clarity on where their central bank stand versus ours. And, well, first of all, it's nice to see some infills into international. I mean, it's been a horrible underperformer for a decade. You know, whatever happened to diversification for crying out loud, it makes you wonder,

you know, people talk eventually about reversion to the mean. You know, if you're supposed to be holding international and you believe that there are companies outside the United States that you don't capture the full just by owning the S&P 500. Right. It's been a pretty disappointing decade. Absolutely. And that's been a cause of constituency issues, right?

U.S. is all tech and growth. Internationals, value, banks, staples, not really the most productive assets over the last decade. But maybe that's changing. We'll see, obviously. But I think at least to start the year, and over the last few months, investors have been a little bit more comfortable

with that exposure rather than the big cap tech exposures. So bond inflows have been, again, also strange. Generally, outflows from high yield, outflows from corporate. This seems to be suggesting to me that people are a little concerned about the situation with corporate America. Right. And yet huge inflows into treasuries. I keep joking. I made my mother the butt of many jokes in the last month because she called from her bank,

literally saying, my God, I was going to roll a CD over a one-year CD. They're offering me 4%. I haven't seen that in years, Robert. This is fantastic. I'm thinking of pulling more money out of my account, my savings account, and buying two-year treasuries or CDs. And I said to her mom, this is why the banks are down a little bit because they're worried they're going to have to pay more for your deposit

and it's going to hurt their profitability. And she said, Robert, I could care less about the profitability of the banks. I got 0.3% for years. And so now my mother's become a bond maven. She's waiting to roll over her CD that way because she thought she was going to get more if she waited at it. another week. When your mother calls about that, that's the sign of a yield top. I think I tend to agree with you there in terms of topping yields. Now, just to rewind on the

corporate and high yield, I think that's consistent with the outflows from U.S. equity, very skittish attitude, is not reseeking. And then with bonds, the, I mean, when was the last time money markets, we're the topic of the day or cash-like ETFs. We haven't talked about these things in years. And in some cases, since they've existed, And this is kind of what happens when you go from a decade of 0% interest rates to 4% to 5% very quickly. It's like putting a jar of M&Ms in front of a 3-year-old kid. They just go wild. Now, the topy part of yields, I think there's a little bit of a rush here because investors are perhaps worried about the recession aspect.

And so that may also be pushing down yields. Everyone wants to get that last grasp of 4% or whatnot, such as what your mother is. saying, but I would suspect these continue, especially as equities are still in a, is it a new bull market, is it not a new bull market type of environment, whether this becomes two offsides down the line, we'll see, similar to other hot categories over the last few years, but everyone is just loving that they can get 4% yield on cash-like funds and sit there and be happy. So a year from now, the one year is between 4% and 5%, let's just play it wide. Is it your best bet that yields will be lower or higher one year from now?

I'm inclined to say lower. I think they've had an excellent run. But now you're getting to the point where you're at levels not seen in a couple of decades. And then, again, the recession aspect, I think is scaring a lot of investors. So I'm inclined to just think lower. I think folks are very happy with the risk reward you're getting from treasuries. My mother got the yield top. She actually did.

I got a hand to her. Thank you very much for talking to us. Todd Sone is the ETF and technical strategist as strategic securities, and that is our ETFA podcast for the week, and thank you for listening. InvescoQQQQ believes new innovations create new opportunities.

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