Defined Outcome ETFs

Defined outcome ETFs are equity investments that offer some downside protection in exchange for a cap on the upside over the course of a year. They are usually tied to the performance of the S&P 500 or another index in the US and abroad. Some offer downside protection or buffer of 9% to 15%. Others are created in such a way that the first 5% decline is on the investor but there is protection on the next 30% decline. The trade-off is a cap on the potential upside. In other words, you receive downside protection in exchange for limited upside. These types of investments could look very attractive as a bond replacement because of the current low yield environment. 

Let’s look at an example using a 9% buffer. If purchased on day one, an investor would not lose money unless the market was down more than 9% a year later. In exchange for that buffer, the investor would not make more than about 15% or 16% even if the market was up more than that. In the last 95 years, the market dropped more than 9% 13 times. Five of those drops would have resulted in less than a 5% loss. During that same time period, the market returned more than 16% 44 times.

The 15% buffer works identically to the 9%. In this example, the upside would be capped around 9.5% to 10.5%. This is lower than the 9% buffer because the downside protection is greater. In the last 95 years, the market dropped more than 15% 6 times. During that same time period, the market returned more than 10.5% 55 times.

The 30% buffer works slightly different. Unlike the other two, the first 5% decline from day one is on the investor. This means that if the market is 5% lower one year later, the investor takes that loss. However, if the market declines 30% more (35% total) the investor would only lose 5%. In exchange for this enhanced protection, the upside cap is about 7% to 8%. In the last 95 years, the market dropped more than 35% 2 times. In one of the 2 times, the additional loss would have only been 2%. During that same time period, the market returned more than 8% 56 times.

While the upside limit is capped in each of these examples, this type of investment can offer some peace of mind. With bond yields so low and their future returns potentially limited, defined outcome ETFs could be used as a fixed income substitute without being classified as fixed income.