January 2024
What is your title and current role at Innovator?
My role is Director of Capital Markets. Our team oversees the product ecosystem for the Defined Outcome ETFs. We support client engagement and the firm’s external relationships across the ETF ecosystem. This includes big players like Authorized Participants (APs), market makers, banks, custodians, and exchanges.
Another exciting aspect of my role is contributing to product development efforts and the firm’s launch strategy. Innovator is the pioneer in this space and after launching the world’s first Buffer ETFs, we aim to remain at the forefront of innovation.
What is your typical day at Innovator?
My job entails two primary functions. The first is expanding partnerships with key institutional firms to create an ecosystem that’s conducive for the ETFs to scale/grow efficiently. The result is a deep network of support for the products and our clients.
The second is working directly with clients. We’re answering all their questions about the ETF ecosystem, market structure, product structure, and liquidity/trading. We’re an expert resource to the sales team and the firm’s distribution efforts. I’m constantly hopping on calls and helping advisors/institutions think about product structure, liquidity, and implementation of the Buffer ETFs.
Are you helping to provide liquidity to these products as well?
We are, yes. We aren’t directly providing liquidity – market makers do that. We’re the ones that bring new market makers into the fray. We strike new partnerships with these groups, demonstrating the rapid growth in this Defined Outcome space and that they should be supporting these products, which ultimately translates to a simple trading experience for advisors. The other important aspect of my role is working directly with clients on implementation. In addition to clients’ internal trading desks, our team is available to assist clients pursuing the best price on Innovator ETFs, regardless of the trade size. Buffer ETFs are very liquid and simple to trade, but advisors still value another set of expert eyes as they get comfortable with a new ETF. We are those eyes. Our team has real-life experience as ETF traders from prior roles and deep relationships with the largest trading firms, banks, and custodians. If a spread looks wider than normal, or if your trading desk wants to make sure it’s getting the best price, we are available to assist.
Can you give a simple definition of an Authorized Participant (AP)?
An Authorized Participant is an institution, typically a bank or trading firm, that has a signed agreement in place with an ETF issuer to create/redeem shares. This agreement allows them to create and redeem shares of the ETF in large blocks, known as creation units.
Creation Units is another term that you’ll hear often in the ETF world. Every ETF, not just Buffer ETFs, has a CU (creation unit) size. A common creation unit size in ETFs is 25,000 or 50,000 shares. For example, Goldman Sachs and BAML have AP agreements signed with Innovator. This allows their trade desks to place orders directly with Innovator to increase an ETF’s shares outstanding with a creation, or decrease an ETF’s shares outstanding with a redemption.
How are shares created and redeemed within an ETF?
Creation/redemption is a phrase that’s thrown around, but most people outside of the industry are less familiar with it. The creation/redemption process allows ETFs to maintain a tight correlation to their underlying basket (or net asset value – “NAV”), uphold tax efficiency, and trade intraday on an exchange like a stock. When a “creation” occurs, there are excessive buyers on the exchange and demand exceeds supply for the ETF. A creation involves an AP buying the underlying securities in the ETF, packaging them up, and delivering them to the issuer to create new ETF shares (increasing AUM). A “redemption” is the opposite – there’s excessive selling on the exchange and supply exceeds demand for the ETF. For a redemption, the AP delivers ETF shares to the issuer, and the issuer returns the underlying securities to the AP, reducing the ETF’s shares outstanding (decreasing AUM).
Why does this happen, in practice?
Well, an AP (usually a market maker) places a creation because they’ve been selling shares to meet market demand. To meet this demand, the AP accumulates a short position in the ETF while simultaneously purchasing the ETF’s underlying securities along the way to hedge the position. At the end of the day, the AP collapses both positions by delivering the ETF’s underlying securities (or cash equivalent) to the issuer in exchange for new ETF shares. The AP then uses the new ETF shares to close the short position in the ETF. Voilà, the securities are in the fund and new ETF shares have been created to satisfy market demand.
Innovator works with how many APs?
We have more than 14 APs for our suite of ETFs and work with even more market makers. These include the largest banks and most advanced trading firms in the world. We are building an all-star bench of institutional support for the products as they become a staple in investors’ portfolios.
Can you explain how an in-kind redemption differs from a cash redemption?
Yes, certainly. In-kind redemptions are one of the more elegant characteristics of ETFs. ETFs predominantly employ “in-kind” creations/redemptions, which simply means exchanging ETF shares for a basket of securities. This is different from a “cash” redemption where cash equivalent is exchanged instead of underlying securities. Why is this significant? When a mutual fund investor asks for his/her money back, mutual funds sell securities to raise cash to meet a redemption. This may create a taxable consequence for remaining shareholders. When an investor sells an ETF, they sell it on exchange to another investor or market maker, instead of directly to the fund. This reduces transactions directly with the fund, lowering turnover and creating economies of scale for shareholders.
If there’s excessive selling on the exchange, an AP places an in-kind redemption order. In this scenario, the issuer doesn’t need to sprint out and sell holdings to pay an AP in cash. Instead, the issuer pays the AP “in-kind” by delivering the ETF’s underlying holdings, instead of all cash. This exchange is not considered a taxable event, reducing any potential burden on remaining shareholders.
This gets back to the ETF wrapper being the premier vehicle for Buffered ETF exposure. Similar payoffs have historically only been available in structured notes and annuities. Buffer ETFs exploded in popularity because of visionaries (Bruce Bond and John Southard) who discovered a way to deliver this exposure inside of the ETF wrapper.
So, the in-kind redemption is not going trigger a taxable event?
Correct. The in-kind transfer is just that, a transfer, not a sale. One detail to note is that with an in-kind redemption, the ETF issuer may select which securities to deliver to the AP. The ETF issuer may deliver out securities with the lowest tax basis, leaving the fund with higher cost basis securities. This is how ETFs effect tax-efficiency and avoid making capital gains distributions. It’s important to note that this process isn’t avoiding taxes. This process simply defers taxes for the benefit of shareholders.
So, you don’t anticipate Innovator’s Buffer ETFs will make taxable distributions?
To preface, I can’t provide tax advice and investors should rely on their own qualified professionals for tax advice. Having said that, we do not anticipate paying out any capital gains distributions for these ETFs going forward.
Innovator pioneered the use of FLEX options in the ETF wrapper to deliver built-in downside protection. The other thing we did was help forge a path to ensure investors receive the same tax efficiency with our Buffer ETFs that they are used to receiving with traditional equity ETFs.
In 2019, the SEC approved a Cboe rule change, spearheaded by Innovator, allowing for the in-kind transfer of FLEX options in the ETF wrapper. This was a critical moment because it unlocked the tax efficiency which became the industry standard for these products. At the time, FLEX options were mostly used by various institutional investors and rarely seen in ETFs. Now, FLEX options have exploded in popularity alongside the growth of Defined Outcome ETFs. Allowing for the in-kind transfer of FLEX options was a key development for the ETF industry.
Can an investor choose to trade the options on his own, outside of an ETF wrapper?
This is a great capital markets question because we field this question often from retail investors, advisors, and institutions. They ask, “Can we do this ourselves?” And the answer is, in most cases, no.
Let’s dissect this because I think it’s really interesting. First, managing options is burdensome, and can lead to user error and most advisors aren’t even allowed to trade options. We’ve seen issues with clients who’ve come to us after trying to manage option overlays. They had a dedicated trader focused on it and still made costly mistakes. It can be complicated and onerous. Receiving similar exposure through an ETF reduces operational risk. There are also other hurdles. For instance, there’s a minimum investment threshold for FLEX options.
The second key point I’ll highlight is the liquidity network. If you’re a retail investor, advisor, or smaller institution, you don’t have access to Innovator’s liquidity network. These are relationships, an ecosystem, that we’ve developed over many years. We use a competitive process when we trade/reset the Buffer funds. We place a group of leading option market makers in competition to give us their single best price on the option basket. Garnering the attention of these top trading firms and banks in the world would be nearly impossible if you tried to execute this yourself on a smaller scale. We’ve been told by market makers that the ETF liquidity network can add hundreds of basis points of additional upside potential (cap) vs. a DIY approach.
Lastly, tax-efficiency is lost when trading outside of the ETF wrapper. Buffer ETFs reset to a new outcome period within the ETF wrapper. This means at the end of a 12-month outcome period, an investor can hold without a taxable event, and receive a new upside cap/downside buffer. The investor only realizes a gain/loss when he sells the ETF. If this same investor held options, he’d be forced to pay any capital gains on expiry for those options.
Milliman is the sub-advisor on Innovator’s Buffer ETFs. How do you work with Milliman?
We work very closely with them. They manage the day-to-day trading, operations, and tracking of the Buffer ETFs. Whenever we see a creation or redemption, or the funds rebalance to new outcome periods, the sub-advisor oversees the trading and is instrumental in hitting the stated defined outcome. Milliman is a firm of experts dedicated to risk management and they oversee a multitude of strategies for institutional clientele. They’re hyper-focused on hitting these benchmarks that we have in place.
If an advisor places a large trade in one of your Buffer ETFs, do you see the order come in and does Milliman also see it?
We do. Some clients like to reach out to us before they trade and others don’t. The market has matured to a point where trading Buffer ETFs is very simple, but whenever a creation or redemption comes in, both Innovator and Milliman see it. At the end of the day, we aggregate all the activity that’s happened in the funds and adjust the exposures accordingly. This will occur whenever there is creation/redemption activity.
Please give us your definition of FLEX Options and how they are different.
FLEX options are an amazing tool. When you hear FLEX, think “flexible.” FLEX options let you customize the strike price and expiration date of the options to whatever you choose. Despite this customization, FLEX options still trade on an exchange, so they’re backed by the full faith and credit of the Options Clearing Corporation.
Should advisors or investors be concerned about the low volume on some Buffer ETFs?
No, they should not be concerned. The age-old mantra for ETFs is that the underlying basket defines an ETF’s liquidity, not volume. The liquidity of an ETF starts with its basket. Don’t get caught using stock logic when it comes to ETFs. For a stock, the volume may be a key determinant of liquidity for that specific name. With ETFs, you need to peel back the onion and see what the ETF is holding to understand its liquidity profile.
An ETF tracking the S&P 500 (SPY) may have 0 shares traded on the day. It may not have traded for a week, maybe even a month – no trades on the tape. Regardless, that same ETF could likely facilitate a $100 million trade with minimal impact on the bid-ask spread or the underlying market. Why? The ETF’s underlying or implied liquidity is the key driver. In this case, the underlying liquidity was S&P 500 stocks. If it’s small-cap Japanese equities, well, that’s going to have a much different (lower) liquidity profile than S&P 500 constituent stocks.
Innovator intentionally chose the most liquid benchmarks (SPY, QQQ, IWM, EFA, EEM) when they introduced Buffer ETFs to the market, specifically to support large capacity and deep liquidity.
A typical advisor or investor could look at the expense ratio of a Buffer ETF and decide they are quite a bit more expensive than other ETFs, but you’ve mentioned to me in the past that the publicized expense ratio doesn’t tell the whole story. You’ve said the Total Cost of Ownership is what’s critical to understand. Please explain further.
The Total Cost of Ownership (TCO) is the all-in cost to own an ETF. Most investors only think about the management fee when evaluating the cost of a financial product. As a former trader, my perspective is a little different. I like to consider all the variables that affect my return when I make a purchase. So, one thing I would call investors’ attention to is the bid-ask spread and execution costs when evaluating an ETF.
How wide is the ETF’s bid-ask spread? Let’s say an ETF has an expense ratio of 0.25% with a 0.75% bid-ask spread. We’ll call that ETF A. ETF B has the same exact exposure, but offers a 0.30% expense ratio with a bid-ask spread of 0.10%.
Most investors will choose ETF A because of the lower expense ratio, but ETF B is actually cheaper from a TCO perspective. Think about that for a second. Assuming equivalent performance, it’ll take the investor of ETF A several years to recoup the spread costs for it to truly be less expensive than ETF B.
If you encounter a wider spread, it may be possible to get trades done within the spread. This is where consulting an ETF issuer’s Capital Markets desk can be useful.
One of the best qualities for Buffer ETFs is their transparency. There are no hidden fees, surrender charges, or load costs that you may find in legacy structured products or mutual funds. Investors can easily view the ETF’s bid-ask spread, where trades have occurred, and the expense ratio, to evaluate their total cost of ownership. Buffer ETFs also maintain tight bid-ask spreads in comparison to products attempting to deliver similar exposure in different wrappers.
Please explain why Buffer ETFs do not have credit risk.
A key differentiator for Buffer ETFs versus traditional structured notes is that they’re not a debt obligation of a specific firm. That’s very important because as we saw with Lehman Brothers and Credit Suisse, when issuers hit speed bumps or become insolvent, their debt/shareholders may suffer the consequences.
The FLEX options in a Buffer ETF are guaranteed for settlement by the full faith and credit of the Options Clearing Corporation (OCC). Why is that important? The OCC is one of eight organizations declared a SIFMU (Systemically Important Financial Market Utility) by the U.S. government. In layman’s terms, this means it’s an organization vital to the U.S. financial system, and its failure or disruption could threaten the stability of markets. Every investor I’ve spoken with prefers that risk to the credit risk of a specific bank/institutional entity.
Changing gears here…how did Buffer ETFs perform during the Covid Crash? Did they perform as advertised?
They delivered as stated. The COVID Crash was a hallmark example for Buffer ETFs performing as advertised amid historic volatility. In fact, we use the COVID Crash experience to illustrate the liquidity and dependability of Buffer ETFs in periods of market stress. In addition to hitting their stated outcomes, they also maintained tight spreads during this tumultuous period.
This wasn’t the case for all ETFs. Many low volatility ETFs, on the other hand, actually experienced sharper drawdowns and higher volatility than the broad market. This caught a lot of people by surprise in 2020. There are factor investors out there who believe in the long-term outperformance of low volatility, but there was definitely a subset of investors in those products that expected a smoother ride. Buffer ETFs, on the other hand, did what they were supposed to do – they buffered against losses and reduced volatility/drawdown. So, that was a crucial positive case study for Innovator.
Burke, is there anything else you think might be of interest to the reader?
Taking a step back, the ETF wrapper will go down as one of the most versatile and disruptive tools in financial services history. Since Day 1, ETFs have consistently ripped away market share from mutual funds. What’s even more exciting is to be a part of the disruption of new asset classes by ETFs.
What I mean by that is, we started with basic equity ETFs, which was innovative in and of itself. Bruce and John were pioneers there – launching the first thematic and smart beta ETFs. Now, we’ve seen ETFs penetrate fixed income. The ETF wrapper has completely turned the fixed income world upside down. Fixed income ETFs have driven liquidity and price discovery into a historically illiquid asset class, bonds. If you look at COVID markets, a lot of the underlying bonds weren’t trading, but the ETFs were. The ETFs actually served as price discovery tools for the underlying bond market, which was interesting.
Defined Outcome ETFs, and more specifically Buffer ETFs, have smashed open yet another door for investors: structured products. This exposure was previously only accessible to high-net-worth individuals and institutions. All investors now have access to built-in risk management at a fraction of the cost. Innovator unlocked an entirely new asset class for ETFs with these solutions. The ETF will continue to drive low-cost, transparent, liquid, and scalable solutions into the hands of investors. It’s a game-changer. Defined Outcome ETF investing is here to stay and we’re just beginning to scratch the surface.
Thank you, Burke.