Say you’re retired or soon to be.  You know stocks outperform bonds over long periods of time, but with significant short-term volatility.  Would you be interested in an investment product that allows you to participate in price gains in stocks (up to a limit), while also offering downside protection?

Wall Street has an insatiable appetite for fees and unmatched ability to spot a hot trend.  In 2020 the Securities and Exchange Commission adopted a “modernized regulatory framework” for “derivatives” (like options contracts) used by mutual funds and exchange-traded funds (ETFs).  Financial product designers have a keen understanding of investor psychology and are expert at giving speculators and investors what they crave, whether it’s the “action” of 3X leveraged ETFs (which magnify gains and losses on an index) or the perceived safety of ETFs that promise enhanced income or the chance to chase stock returns while also protecting against declines.

According to The Wall Street Journal, the latter category was almost nonexistent four years ago (prior to the SEC’s new rules), but has exploded in popularity, taking in $31 billion of new investor money over the past 12-months and bringing total assets to $120 billion.  Eric Balchunas, senior ETF analyst at Bloomberg Intelligence, dubbed these funds “boomer candy” and explained their attraction to risk-averse investors who “like being in the stock market but want the protection that helps you sleep at night.”  Not surprisingly, “a good chunk of the ETF industry is in the lab trying to design more of these funds as we speak.”

In essence, investors purchase downside protection in exchange for surrendering the upside over a stated amount.  We certainly understand a 60-year old’s desire for lower volatility, but by the same token that investor needs to understand there is no free lunch and there’s a significant long-term cost to capping the upside.

Further, in our May 3 column, “Risk and failure indispensable to your investment success,” we argued risk is the permanent loss of capital, not price volatility because “although stock prices are driven by fear and greed over the short-term and are very volatile, the value of the underlying businesses don’t change that much from day-to-day.“  We highlighted Oaktree Co-Chairman Howard Marks’ memo, “The Indispensability of Risk,” where he explained the risk of not taking risk. “Because the future is inherently uncertain,” he wrote, “we usually have to choose between (a) avoiding risk and having little or no return, (b) taking a modest risk and settling for a commensurately modest return or (c) taking on a high degree of uncertainty in pursuit of substantial gain, but accepting the possibility of substantial permanent loss.”

Nick Cordola, CFA summarized the appeal and sales pitch on ETF Trends.  “By reducing volatility and max drawdowns,” he said, “these financial sweet treats seemingly make equity risk more palatable for Boomers, helping them weather the equity market hiccups and stay invested for the long-term.”  Further, “by providing downside buffers, it also reduces a retiree’s portfolio withdrawal timing and horizon risk—the risk of withdrawing funds at an inopportune time which impairs their future prospects. As Mary Poppins said, ‘A spoonful of sugar helps the medicine go down.’”

Examine the “ingredients label” on one of these actual “sweet treats,” which we’ll refer to as ETF A.  According to the prospectus, ETF A “seeks to provide investment results that, before taking fees and expenses into account, match the positive price return (not total return) of the SPDR S&P 500 ETF up to a cap of 9.45%, (8.76% after expenses) while protecting against 100% of the negative price return (99.31% after expenses) of the SPDR S&P 500 ETF, for the period from July 1, 2024 through June 30, 2025.”

Both the return cap and protection are based on and assume 1) you purchase shares on the first day of the “outcome period” (July 1, 2024) and hold for the entire period.  If you purchase or sell shares during the period, your return cap and protection will be different (ETF A’s sponsor provides daily updates).

ETF A seeks to provide the “capital protected targeted outcome” utilizing a “witch’s brew” (our term) of customized ‘put’ and ‘call’ “Flex Options” (derived from future price changes of the SPDR S&P 500 ETF) it purchases from and sells to various counterparties.  It’s a complex recipe and not foolproof.  Indeed, ETF A warns in periods of extreme market volatility or during market disruption events (precisely why the owners of ETF A purchased it in the first place), ETF A’s ability to offset investor losses or provide returns up to the cap with FLEX Options “may be impaired.”

We express no opinion on ETF A, but prefer simple vs. complex recipes.  Another major change from four years ago is the yield on the 1-year US Treasury (UST) has gone from around 0% to 5% (risk-free).  We ran a 10,000 iteration “Monte Carlo Simulation” on future 1-year S&P 500 returns.  A simple, do-it-yourself portfolio consisting of 70% SPDR S&P 500 ETF/30% UST outperformed ETF A nearly 75% of the time.

Maggie Kamman, CFP, CMA contributed to this column. 

The opinions expressed in these articles are those of the author as of the date the article was published. These opinions have not been updated or supplemented and may not reflect the author’s views today. The information provided in these articles are not intended to be a forecast of future events, a guarantee of future results and do not provide information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell any particular stock or other investment.