What inspired you and John Southard to start Innovator ETFs?
We started Innovator because we believed there were limited investments in the marketplace that provided quality equity risk management to investors.
What was your goal in bringing Buffer ETFs to the marketplace?
Our goal was to open the minds of investors to understand that there were superior ways of thinking about exposure and participation in the equity markets.
What are the primary advantages of owning Buffer ETFs?
The primary advantage of owning Buffer ETFs is being able to maintain exposure to the market’s upside potential, with a known level of built-in protection on the downside.
Obviously, Innovator has already had tremendous success, but were there any particular early hurdles you faced?
Our initial hurdles were getting the products approved by the SEC. It took more than a year because there had never been another defined outcome ETF introduced. We always thought if we could launch a product that provided compelling payoffs, investors would engage with those ETFs. One of our biggest hurdles was educating investors on how they work and why they make sense as part of a portfolio.
You’ve raised billions mostly through Registered Investment Advisors. Have there been any particular Buffer ETFs or strategies that have appealed mostly to RIAs and their clients?
Initially the 12-month Buffers on the S&P 500 were the main attraction for the RIA community. Since then, the interest has broadened out into other markets and profiles, including quarterly outcomes and accelerated exposures.
For moderate-risk investors already in retirement or nearing retirement, which of your offerings might be the most appropriate for them?
One of our most successful offerings is the 15% buffer strategy. This seems to be the level of protection that has had the greatest appeal to investors in or nearing retirement. Our 20% quarterly buffer strategy is another one that has seen steady inflows as investors have used it for a defensive allocation that doesn’t carry any interest-rate risk or credit risk.
Are some of your Buffer ETFs more appropriate during bull or bear markets, or sideways, range-bound markets?
The beauty of Buffer strategies is that investors don’t have to worry about whether the market goes up or down. If the market goes up, a buffer strategy will participate to a predetermined maximum level, and if it goes down, the strategy offers the chosen level of protection. The smaller buffers that have higher caps tend to perform better in positive markets, while the bigger buffers tend to perform better during bear markets.
What strategies are typically recommended by advisors if we are deep in a bear market? And, what would be a recommended strategy if we are at very lofty stock-market valuations or even potentially in a euphoric bubble?
Whether we are in a bull market or a bear market, the preferred buffer level typically boils down to the risk tolerance of the investor and where we are in the market cycle. For example, after an extended bull market, valuations are often stretched. In that kind of scenario, investors begin to believe the market could reverse course, causing them to get out of stocks, or at the very least to stop adding exposure. This approach is beneficial if the market falls, but detrimental if the market continues to climb. We see greater demand for buffer strategies in circumstances like this; if the market does go down, the buffers provide built-in protection, but if it doesn’t, the strategy will participate in the continued positive performance.
Are most investors and advisors using your ETFs in a passive manner or are they actively managing portfolios and looking for opportunities intra-outcome period?
A large majority of investors are using them to replace equity exposures over a full outcome period, but we do have significant interest from investors who are looking for unique intra-period opportunities.
Buffer ETFs can serve as a core holding for investors. Are advisors using them as core holdings now or as a slice of their overall asset allocation for clients?
We have seen both approaches used. Many initially exchanged their hedged positions, which hadn’t performed as anticipated, for Buffer ETFs, and then decided to replace larger portions of their equity exposures or even fixed income exposures with buffers.
If Buffer ETFs can serve as a core holding, why not allocate nearly an entire portfolio in Buffer ETFs?
Over time, progressive advisors are realizing that this will likely be the way to go in the future. Some have begun to transform their businesses already. The poor performance of 60/40 portfolios over the last few years has made investors and advisors realize that bonds aren’t immune from downturns and that relying on historical correlations can be a big mistake.
Innovator recently launched 100% downside protection Buffer ETFs. Are there any Innovator offerings that you find particularly attractive in the current environment?
I think that some of the quarterly and accelerated strategies will be interesting as we move forward. Many of the quarterly strategies remove significant risk and volatility from equity participation and the accelerated strategies have the ability to improve performance during lower-return markets, which we could see over the next several years.
Billions have flowed into Defined Outcome ETFs in the past 5 years. Where is this segment of the ETF marketplace headed in the coming years? How will Innovator maintain its advantage as the leader in the field?
Innovator is the market leader and the driving force behind the Defined Outcome ETF category and we plan to continue to innovate in the space as it continues to expand. I believe the expansion will continue at a fast pace into the foreseeable future as investors realize, through different market cycles, that most investment products that they hold in their portfolios do not deliver on their performance promises. Conversely, with Defined Outcome ETFs, investors can know, before investing, exactly what their investment outcome will be for any given market scenario. In a chaotic world, investors love predictability, and that’s exactly what Defined Outcome ETFs offer.
Thank you, Bruce.
What is your role at Allianz?
I helped set up and develop the ETF business for Allianz. We launched a little over three years ago and we have been building out the business over time. Currently, I focus more on partnerships and more complex portfolio management level discussions with advisors, gatekeepers, CIOs, model builders, and so forth.
Was it a big transition and challenge for Allianz to move into the ETF space? Allianz is primarily known for its insurance products (annuities etc.), so was the ETF marketplace new for Allianz and were you instrumental in starting the business within Allianz?
Yes, I made the proposal and then it took a village, of course, to get off the ground. But, in terms of a natural extension of our business, and as a part of our long-term strategic objectives, it fit perfectly with what we’ve been doing for decades already.
We have the expertise on the insurance side, trading, portfolio management – all the work that goes into building out a trading desk that is squarely focused on managing risk – that’s kind of the crown jewel of what we have, and what we’ve been doing for a long time.
Being new to the ETF space, we had to tap into the ETF ecosystem and build that out, and that takes a little bit of time to get the components put together. The core of what we do centers around risk management. Our portfolio managers have been trained to “hit targets.” On the insurance side, we provide guarantees to people, and we collect premiums that we’re then investing to make sure that we can deliver on those guarantees. So, risk management is a critical function for the company and everything we do is built around that.
Would you say Allianz is using many of its existing strategies, but in a different investment vehicle with Buffered ETFs?
Right. So, we have annuity products that have caps and buffers, and different variations of structures on different indices. So that’s not new to us. That’s something that we manage and know very well.
In terms of options trading within our ETFs, we use FLEX options. We’re not new to this type of structure either. The beauty of FLEX options is that they’re customizable to get a particular outcome. We were one of the early institutional investors in FLEX options dating back some 15 years ago.
And then in terms of options volume, we’re one of the biggest traders of options in the United States as well. Probably a little-known fact is that we trade options every day in the billions of dollars – give or take up to $10 billion a day and in the trillions every year.
Do you offer both annuities and structured notes?
We offer annuities and ETFs, but we don’t have a structured notes business.
Have you found that your existing clients also have an interest in your Buffered ETFs? Have you heard some positive feedback from those clients?
Yes, we have. Buffered ETFs are a complementary product for many advisors. For advisors that are already using annuities and have command of the language around annuities and how they work and the benefits that they provide, it is a very quick leap for them to start thinking about what Buffered ETFs might be able to do for them on the wealth management side or the asset management side of their businesses. These advisors are obviously not investing all of their clients’ assets in insurance products. They also have asset management products to consider. And, once you have a good feel for the trade-offs with the cap and buffer type of strategy or a defined outcome strategy, on the insurance side, it’s very easy to also then transpose that knowledge into the liquid side where you can trade that in an ETF.
How many Buffered ETFs does Allianz currently offer?
We have a few of them now, and we’ll keep adding strategies. We have a 10% buffer on the S&P 500, specifically on the SPY ETF, with a 12-month outcome period. And, we also have a 20% buffer with a 12-month outcome period, also on SPY. And the third buffer strategy we have is a 10% buffer also on SPY, but with a 6-month outcome period. With our monthly series of funds, we have a total of twelve 10% buffer ETFs and twelve 20% buffer ETFs with 12-month outcome periods that start on the first day of each month. This provides diversification opportunities across various time periods and enables investors to enter on “Day One” of an outcome period every month of the year. Our series of 10% buffer ETFs with 6-month outcome periods is being completed this year to include a total of six ETFs so that we have outcome periods that start and end every month of the year. February 1, 2024, we launched a new Floor Strategy, also on SPY, with a 5% floor (maximum loss) and a 6-month outcome period, and we have other products in the pipeline.
How much money is Allianz managing in Buffered ETFs now?
We launched about three and a half years ago in the midst of the COVID pandemic. It was June 2020, so it was very difficult to gain traction early. Plus, we were trying to staff up and figure out the staffing model and distribution models in an environment where nobody came to the office. So, we had a bit of a slow start, and it took us almost 3 years to raise the first billion dollars, but then it took only 10 months to raise the second billion. And now we’re at $2.3 billion across these strategies.
Are you mostly raising money through advisory channels?
Yes, we’re 100% focused on advisors and institutional buyers. And, the key here has really been on education, because this is still a relatively new asset class. It’s been growing rapidly as an industry, but it takes time. It is the traditional Adoption Curve. You have some early adopters, and then you have some that want to watch and learn over time and maybe come in a little bit later.
Are you seeing most advisors use your ETFs as a slice of the overall asset allocation pie? And, are you seeing more advisors now leaning towards perhaps making it a core holding in a portfolio?
So, let’s go back to the Adoption Curve – it’s actually all over the place. And, some of it depends on which side of the business they’re on. If you’re on the RIA side, you can implement this however you see fit for your clients, and that can range from a sliver to a much bigger allocation, to a full allocation in some cases.
And then on the broker-dealer side, it might be a little bit more restrictive, in terms of how assets are classified. So, there might be restrictions in terms of how big of an allocation you can have. But, to answer your question a little bit more directly, typically we see a 10% allocation tends to be a starting point, or a minimum, for advisors. And then it goes up to where we see some advisors completely replacing their fixed income allocation and buying Buffered ETFs instead. So, it may go up to 40% or more. It’s a wide range.
Was 2022 a turning point for Defined Outcome ETFs? Investors were losing money in both stocks and bonds, which typically are somewhat uncorrelated, but that wasn’t the case in ‘22. Do you believe that when markets are difficult and investors are losing money, is that when they start to look for a better solution?
I say human nature guides you and you feel pain points 5x more heavily than the positive points. So, when bad events happen, your brain automatically kicks into survival mode and you try to do something about it because it doesn’t feel right. And when things don’t feel right, you want to take action. And, a lot of times in the investing world, you take the wrong action and you make a bad decision.
Did more eyeballs turn to these strategies in a year like 2022? Yes, there’s no doubt. They turn to anything that looks like a “risk-off” asset, but one of the benefits of the defined outcome space is that it helps mitigate poor decision-making that frankly is somewhat pervasive. If you are invested in these types of products, then you won’t feel as much pain and you will be less inclined to make poor decisions when the sky is falling, so to speak.
Now for the industry, just one more point on that, 2022 was clearly a gift to the defined-outcome industry because it served up a lot of different proof points. One being, trading liquidity with big trades going off without a glitch. And, the second one, was the fact that in the case of our 20% buffer, for example, I mean, we couldn’t have seen or dreamt up a better proof point because the market was down just about 20%. And, our 20% buffer didn’t lose money – basically flat (gross of fees). It really demonstrated how these products work.
If I can add one more thing, 2023 served as the second-best proof point that you can think of because the market rallied. So now an investor who had “hypothetically” invested in our 20% buffer throughout 2022 – let’s say he invested $1 million, so he would still have $1 million at the end of 2022 (gross of fees). And, as the markets rallied by over 25% in 2023, he then participated up to a cap that was set at approximately 15%. He would have had $1.15 million at the end of the year. But if you were in the S&P 500, you would have only been back to $1 million (loss of 20% in 2022 and gain of 25% in 2023). So, it really demonstrates the diversification benefit and the “win more by losing less” concept. The numbers really played out favorably for these types of products, not because of what they helped drive in terms of AUM growth, but because it demonstrated how they work and that they do indeed work as intended and as advertised.
Have you found that advisors are using your products with tactical strategies and making changes intra-outcome period – locking in profits, creating a new buffer – or are they passively invested?
So, the majority of advisors are thinking about this as an allocation. A strategic allocation to Buffered ETFs provides diversification and portfolio level downside protection. But at the same time, there might be some active management of that allocation in that they can rotate in and out of different Buffered ETFs depending on where they’re trading in relation to the caps and what the market’s doing. So, perhaps a passive allocation, but with some active management inside of it. So that’s one type of investor.
The other type of investor who wants to be more tactical and perhaps try to beat a benchmark, say a 60/40 benchmark, for example, that would imply that they have a market opinion and want to implement that either by overweighting or underweighting equities. So, one of the really cool things with Buffered ETFs is that if you’re overweight equities because you have a positive view on the economy, let’s say, but instead of buying just more equities at the expense of fixed income or cash (where you will immediately be judged if the market declines and you underperform) – instead, you could buy Buffered ETFs.
If you buy a Buffered ETF and your bet is wrong and the market goes down, you’re still “buffered” against that loss. And then, of course, if the market goes up, then you’re right, and you get to participate. And even if you get capped out, well, you still likely generated alpha in your portfolio. So, it’s hard to lose in that case.
And, in a declining market you’re always going to outperform in Buffered ETFs.
That’s right. And, no matter how far down it goes, you will still outperform. And if it goes up, you will participate all the way up to the cap, and it’s only if the market blows beyond the cap, that you’re underperforming. But keep in mind here, importantly, you’re underperforming the S&P 500 in that scenario. But, if you’re replacing an alternative allocation or a bond allocation, for example, and let’s say you get capped out and make 12% in your Buffered ETFs, for example, you’ll likely still outperform the bond allocation and potentially the alternative allocation as well. So, you might still be a winner depending on how you’re thinking about this.
Tell us more about your new Floor Strategy ETF and why this strategy might be attractive? And, what is the advantage of a 6-month outcome period?
The Floor Strategy effectively is in place so that you can lose no more than 5% over the course of the full outcome period (gross of fees). Our fees are 74 basis points, annualized, which means it’s half of that for a 6-month period.
So, it can be used as a very conservative allocation for any investor, frankly. It gives them confidence that no matter what happens in the equity market, they’re only exposed to a 5% maximum loss.
And, we intentionally cut the period down from 12 months to 6 months so that you have an opportunity to have higher delta exposure to the S&P 500 as it’s going up, because in more market environments than not, as you know, the market does go up. This also allows the floor to be reset at a higher portfolio value every 6 months without creating a taxable event, since we do this in an ETF.
When is the 5% Floor Strategy launching? And what are the early indications looking like for the upside cap for the 6-month period?
February 1, 2024. So, for the upside cap, the estimate that’s public right now is between 5.5% and 8.5% gross. The reality is it’ll probably land somewhere in the middle of that range. [Note: The starting cap on the Floor Strategy (ticker FLJJ) was 7.36% net of fees.]
How many options are in the ETF wrapper with your new Floor Strategy ETF?
There are three options. There’s a deep in-the-money call option to get the 1:1 exposure to the reference asset, and then you simply buy the put 5% out-of-the-money, to give you that level to set the floor. And you sell a call, and that sets the upside cap and helps to fund the cost of the protection. It is actually a simple structure, but then managing it at scale, that’s where we come in at Allianz, in terms of the preciseness around the options and the expertise and the tax management, etc.
From what I understand, the first 5% level of protection is the most expensive with Defined Outcome ETFs. So, it sounds like you’re able to make this Floor ETF appealing by giving up protection on the first 5% loss, which basically allows for an upside cap that is still attractive. Is this accurate?
Yes, the most likely losses are just south of 0%. So, protecting against those is more expensive. If you wanted to protect from 0% down, it gets really expensive. But the further down you want to protect, the less expensive it becomes.
What factors influence the upside caps for the 6-month and 12-month Buffered ETFs?
For the buffered products, right now it’s primarily volatility that determines the upside caps, but interest rates also play a role. The Floor is more sensitive to changes in interest rates.
For the 6-month Buffered ETFs we offer, with a 10% buffer, the range on the cap is similar to the Floor cap in the current market environment. So, it gives a really nice dynamic if you’re an investor looking for protection against the belly of the curve as you can invest in the buffer to get the first 10% downside protection, with a similar cap on the upside. Or, if you are more concerned about the tail, and you want to protect against losses south of 5%, then you might want to buy the Floor ETF and have similar upside potential as the buffer. It’s kind of like the mirror image, if you will.
It sounds like it’s a product that could compete with the deeper buffers that some of your competitors offer, where an investor is saddled with the first 5% loss in a declining market. But unlike a deep buffer ETF that might protect say to -30% (-5% to -35%), with the Floor Strategy you get 100% protection beginning at -5%. Is that accurate?
Yes, that’s accurate. It’s a “sleep at night” kind of product. It’s the more conservative version, perhaps, you could say.
What type of investor would find the 5% Floor ETF appealing?
I’d say, generally speaking, both the buffers and the floors are for investors who are willing to give up some of the upside, but they’re not willing to sacrifice downside protection. If you’ve made your money and you’re relying on this money, particularly when you’re in retirement, you’re more concerned about not losing money. And, you’re not necessarily shooting for high returns. You just have to be prepared to underperform when the markets rally quickly and hard. But, most of the time you’ll be in a position where you can be pretty happy about the returns that you’re getting.
As an investor you have to be aware of what you are giving up, as far as the upside cap level, and keep your expectations in check, right?
You have to be willing to go to a cocktail party and say, “I kept my money” you know, as opposed to saying, “I doubled my money.”
Would you say your Buffered ETFs basically create more predictability within typically unpredictable markets?
Yes, and I can tell a client that here are the parameters. Here is the upside. Here is the downside. Here is the time period. I think this is what makes sense for you, and they can say, yes or no. It makes the conversation very straightforward.
When comparing the 10% and 20% Buffered ETFs you offer, do advisors show a preference for one or the other?
There is actually a lot to address in this question. We’ve seen a lot of traction with our 20% buffers. It’s got a bit of a bond “feel” as far as the volatility in the portfolio, but it gives you an allocation that can be providing you a greater upside as long as the equity markets are going up. And it gives you a deep buffer of 20% on the downside. So, we’ve seen a lot of fixed income allocations go into this product. And we’ve also seen a lot of cash positions move into this product for that reason.
We’ve also seen assets come from equities going into our 10% buffer. And one of the reasons is that as you’re looking at the risk continuum of investing, you have the most aggressive investor, and you have the most conservative investor. If you think about going from very aggressive to a little bit less aggressive, the thinking here is that for many decades, it was an automatic, let’s move from equities into bonds. That was less obvious over the past several years. And, the question then becomes…what else could you do with your assets? So, we’ve seen a natural drift when investors and advisors want to reduce their risk exposure. Instead of moving equities into fixed income, you can move that slice of the allocation into Buffered ETFs, and the 10% buffer is not as conservative or aggressively buffered as the 20%, so the 10% buffer is a more natural landing spot for a somewhat aggressive investor who wants to dial it back a bit.
Let me ask you a question about the tax efficiency of your Buffered ETFs. Thanks to the benefits provided by the ETF wrapper, it has really made these products attractive from a tax-efficiency standpoint. Is that also the case with your Buffered ETFs in that they typically do not distribute capital gains?
So, yes, we manage our ETFs to make them as tax efficient as possible but there’s never a 100% guarantee from any ETF issuer that they won’t distribute a capital gain. If you think about ETFs in general and compare them to, say a structured note, the note will mature. You have a definitive end point. And there may or may not be tax implications. The ETFs don’t mature. They exist in perpetuity, and you’re only taxed if you’re in a gain position and you decide to sell. The decision is in the hands of the advisor or investor, as opposed to the asset manager in this case.
Where do you think the defined-outcome space is headed?
In terms of growth prospects, we’re still at the very beginning. Structured products have been around for a very long time, but not in a liquid ETF wrapper that you can buy on your phone if you’d like! So, again, it comes back to ease of use. I think more and more retail investors and advisors are going to see the benefits of these products and asset inflows will continue to grow as awareness continues to spread.
Actually, I’ve been surprised the Defined Outcome ETF space isn’t larger already. We have some incredible feedback from market testing we performed back in 2019, and there is plenty of room for this market to keep growing. And, the lack of literature out there on these products is one of the reasons for the knowledge gap. You won’t find a lot written about this space in the academic world, if you will. But there is plenty written about other types of investment vehicles that invest in similar ways with structured outcomes.
In closing, as it stands now, you’re the low-cost provider for the Buffer ETF space among the larger players. Your expense ratios are 0.74% annually. And, some of your competitors are at 0.79% or higher. Does the lower cost provide a selling-point advantage for Allianz?
To some degree, yes, but a greater selling point, honestly, is the fact that we do all of this ourselves. We do this in-house. We don’t outsource any of the portfolio management or the trading. There is no sub-advisor. So that is much more important to a lot of the people that we speak to. And, having been an asset allocator myself, there is something to be said for doing business with firms that actually manage your money. And yes, we’re the lowest cost S&P 500 Buffer ETF provider among the Top 3 players in this space.
Thank you, Johan.
What is your role at Vest? Please give the reader a bit of background.Jeff Chang and I co-founded Vest Financial (Vest) in 2012. I serve as the CEO, and Jeff is President.
Vest and First Trust (FT) are independent investment firms that formed a partnership to launch a series of FT Vest products. The collective focus is on solving specific investment needs: downside risk management and consistent income. The partnership leverages Vest’s strengths in innovative product design and portfolio management for Target Outcome® products, and First Trust’s strengths as a trusted distributor of diligently designed investment products. The partnership includes more than 180 ETFs, UITs and private funds available in US, Canada, and Europe. Within the ETF space specifically, Vest designs and runs portfolio management for a comprehensive suite of “Buffer” and “Target Income” ETFs.
How did you develop an interest in the Buffer ETF space and what led you to found Vest?
I have been in the “Buffer” space since the early 2000s, long before anyone even dreamed of Buffer ETFs. Early in my career, I worked on teams within an investment bank that manufacture, design, hedge and sell buffer strategies, similar to what you now see in Target Outcome ETFs, but as structured notes. My product design experience, engineering background, and a drive to solve investment problems put me on the path that led me to create and launch the very first Buffer products as registered funds in 2016.
Structured investments (pre-packaged investments generally tied to an index or basket of securities, designed to deliver targeted payoffs for institutional and high net worth investors) originated in Europe, and I started my career on the structured product desk of an issuing bank in London. When the banks wanted to introduce similar products in the U.S., a number of my colleagues and I were transferred here to start a structured note business.
I believe the market appreciates the value in structured notes to deliver targeted risk-return objectives. However, after the financial crises of 2008, and the bankruptcy of Lehman Brothers, the market came to recognize some of their unique risks: particularly concentrated credit and illiquidity risks. For many investors, the allure of structured notes diminished.
In 2012, motivated by an urge to solve for the risks specific to structured notes, I co-founded Vest with the sole purpose of bringing a new class of investments to the marketplace that deliver the benefits (targeted payoffs) of structured notes without their drawbacks. Later that same year, we filed for the first-ever buffer product as a 40-Act fund using FLEX options.
Ever since its founding, Vest, unlike other market participants, has exclusively focused on derivative-based Target Outcome Investments®. As of March, 2024 we have $30 billion in assets under management and non-discretionary assets under supervision in Target Outcome Investments®. Compared to structured notes that may suffer from credit risk, inferior taxation and lack of liquidity, Target Outcome Investments® have the potential to provide better taxation, more transparency on pricing, more cost-efficiency, better governance, daily liquidity, and carry no bank credit risk.
When you started the first structured product in a mutual fund wrapper were there any early hurdles you faced?
We faced numerous unexpected challenges along the way. We wrote up the original thesis for how one could put a portfolio of FLEX options inside a fund that is governed by the Investment Company Act of 1940. We filed for a patent application in 2012. In 2013 we filed with the Securities and Exchange Commission, and it took several years for the product filing to be reviewed by regulatory examiners. This may be an underappreciated fact today; someone may look at Buffer products and assume the path to create them was swift and straightforward. Nothing could be further from the truth.
The “overnight success” of buffered funds was several years in the making, starting with our founding and patent filing in 2012, to introducing the first ever index-based buffer strategy fund in 2016. In the four years between when we filed our patent filing and when we launched the first buffer fund, we worked with exchanges and other market participants to help create and streamline the regulatory and trading infrastructure that enable the trading of FLEX options within a fund.
This diligent work has sometimes come at the expense of us and our partners choosing to delay launches of funds, despite competitive pressure, in the pursuit of a better set of products.
Of the approximately $30 billion that you have under management, what percentage is in ETFs?
A large majority of the assets is in ETFs. However, we strive to make our investment strategies available to a broad number of investors in investment vehicles of their choice. Our suite extends beyond ETFs to include mutual funds, unit investment trusts (“UITs”), funds dedicated to retirement (collective investment trusts, known as “CITs”) and funds that can only be purchased as an allocation within insurance contracts (variable insurance trusts, known as “VITs”). We also offer versions of these strategies, in partnership with asset managers in Canada and Europe.
Have you faced any particular challenges with your Target Outcome ETF structures or with marketing those products?
Some of the early challenges were infrastructure related. It is easy to look at this space now and say, of course, it all makes sense, but one particular challenge was paving the way to be able to trade the underlying options in such a way that they could facilitate ETFs.
There were some challenges on the marketing side too. ETFs offer daily liquidity and here you have a Target Outcome® product that’s going to start on a certain date and typically it will finish its Target Outcome® period and “roll” one year later. So, our initial expectation was that investors would buy-and-hold the investments for a one-year period. And so, we suggested that investors purchase them on the roll date and hold them to the next roll date. Over the years, the majority of investors have adopted the practice of passively holding their buffer funds for longer periods of time, but in the early days there was a lot of active trading within the Target Outcome period. Note, we came from a structured note background where liquidity does not meaningfully exist so everyone held notes until the expiry. So, trading during the Target Outcome period was novel to us and it became important to build tools to inform investors as to the daily potential outcome parameters.
FT Vest, like your primary competitors, has raised the bulk of its money through the advisory community, correct?
Yes, the cornerstone of our business is to put the advisors’ needs at the center, and be sensitive to what advisors want, how they want to use these products, and how they think about them. Understanding the investment problems that advisors face informs our product design, how we build new products, and how we will service the needs of their community.
Would you say most advisors who purchase your ETFs are passively invested for the duration of the outcome period?
Yes. However, early on, even though Buffer ETFs are intended as an investment meant to be purchased and held for at least one Target Outcome period, there was a lot of interest in intra-outcome period trading. Now the number of products has proliferated. There are products for different time periods (three-month, six-month and twelve-month outcome periods), at varying cadence (a version of every month or quarter) and for different buffer levels (e.g., 10% buffer, 15% buffer, 20% buffer, etc.). The proliferation of products, in a way, is a curse of choice in that it puts a lot of burden on the advisor. So, we have seen a shift more towards advisors buying and holding these investments.
Buffer ETFs are used for risk management, but in a way that differs from classical risk management, which is, “let’s put some bonds against our equities to diversify.” Instead, Buffer ETFs offer the contractual certainty of the underlying options contracts to provide risk mitigation. And this style of risk mitigation is contractual in nature as opposed to dependent on past correlations between stocks and bonds holding up in the future. If advisors want to manage risk in a portfolio, in a meaningful way, it takes a decent percentage allocation to a buffer strategy to do that. For example, 5% of a portfolio in a buffer strategy does not make a meaningful difference to the overall risk characteristics of the portfolio. So, advisors have been migrating their usage of buffer strategies over time from a slice to more of a core holding.
Another point is that if these products make up a core allocation, and require actively managing within intra-outcome periods, it becomes a burdensome process. About a year into launching these products, we noticed that advisors were asking for systematic solutions. That’s why we developed solutions-oriented funds like BUFR, the biggest buffer fund in the U.S., that has a “set it and forget it” operational appeal to it.
BUFR is a laddered Buffer ETF, correct, with over $3 billion in AUM?
Yes, it’s $3.73 billion as of last night (April 9, 2024).
So, it’s by far the largest Buffer ETF, right?
It’s by far the largest.
And why is that? Why has it been so popular with the advisory community?
I think many advisors simply want systematic exposure to the kind of a risk vs. return profile that Target Outcome ETFs offer, and BUFR is a single-ticker solution. BUFR and BUFD encapsulate that really well. It was navigable for advisors when there were only a few defined-outcome products, but now there are more than 200 ETFs with different variations. So, a better way for advisors to get the exposure to the unique risk-return characteristics of the buffer strategy, is with single-ticker solutions like BUFR and BUFD.
How much protection do BUFR and BUFD offer?
BUFR is a laddered ETF that holds ETFs that each offer 10% downside protection, and each ETF within BUFD provides protection from -5% to –30%.
What has been the sweet spot for advisors using your ETFs? Do they migrate towards the “10s,” “15s,” or even deeper protection?
10% is the flagship strategy for this space, and it is because of the way the U.S. large-cap equity returns distribute. So, 10% is the sweet spot. For example, if you are concerned that the market is selling off and you are worried about downside risk, 10% is typically the optimal level of protection you will want to have.
A 10% buffer doesn’t provide enough protection in a bear market.
Downside is one side of the coin. Because the downside protection comes at the expense of upside capture, it’s a trade-off.
I am biased towards 10% protection because that’s how the market has voted – that’s where the assets are. Now, if you look at the shadow of the COVID Crash, at that point the deep buffer strategies became bigger asset gatherers than the 10% strategies. So, the 15% started attracting assets a lot faster than 10%. And, of course, as market sentiment changes, these things change. Obviously, the more downside protection you want, the less you are participating in the upside, so your expected returns come down. That is the trade-off.
To answer your question, if you feel the market is toppish, 15% protection seems about right, but if you’re coming out of the depths of the crisis in 2009, you want to be biased towards upside capture. Still, over a full market cycle, I think 10% protection is what the advisory community wants.
In today’s market, with many traditional valuation measures in the 90th percentile, meaning the stock market has only been more expensive 10% of the time throughout history, what level of downside protection would you advise?
I am not in a position to give investment advice without knowing an investor’s individual situation and goals. Every investor’s circumstance and risk appetite are different. Personally, I would gravitate towards a 15% buffer for two reasons: 1) Equity risk premium is eroded away at these valuations to sort of suggest negligible return potential. 2) You look at the relative rankings of asset classes and everything has been repriced in the last two years because the risk-free rate has gone up to 5% and there is a transfer of that to these strategies in terms of higher caps. And so, you probably want to maintain some level of upside participation if asset prices get more inflated. Every investor is different, but for someone who would generally allocate to full equity risk, I’d consider a 15% buffer for that equity allocation.
Are your advisors purchasing Buffer ETFs for pre-retirees and retirees, or for younger clients?
It is my general sense, from speaking with many advisors over the years, that heavier usage is biased towards older clients who are in or near retirement, and tactical usage is biased towards younger clients. Of course, every practice is different. Every investor’s circumstance and risk appetite are different.
The money FT Vest has attracted through the advisory community has come from which asset class? Have Buffer ETFs been replacing structured notes and annuities, or is “new” money coming into these products?
It is certainly new money, and this goes back to one of the questions that you asked earlier about the challenges we have faced. In the beginning, we thought Buffer ETFs were going to attract investors who saw flaws in structured notes. Although that was our original hypotheses, that is not how it actually played out. It turned out that structured note buyers were still very comfortable with owning structured notes.
We had more success with clients who were either looking at these investments for the first time, or who were familiar with structured notes or annuities, but had not participated in those markets because of risks unique to delivery vehicles. These investors and advisors like the fact that these ETFs are liquid, governed under a more stringent regulatory standard, and have less credit risks. They would never touch structured notes because of their credit risk, nor would they touch annuities because of their high fees and lack of liquidity, but they embraced a product that has the same advantages, packaged in a liquid ETF.
Do you think the investing public will embrace these products as they become better educated on the advantages?
There is nuance in these products. And so, we have really concentrated our efforts on educating advisors and building tools for them, and I like to think our competitors have followed us on this path. Advisors make a living in guiding their clients in navigating the nuances and the complexities with these products. Nobody has developed a distribution model to aid the self-directed investor. It is certainly not our business model, but I cannot speak for others.
It’ll be interesting to see if and when that “void” is filled, and the investing public starts to embrace these products.
I think practitioners like yourself, and maybe your book, will help bridge some of that gap, but there is certainly a void for somebody to capitalize on, or to at least address.
Just a couple more questions for you, Karan. Most of your competitors chose the last business day of the month as the roll/reset date for their Buffer ETFs. FT Vest chose the third Friday of the month, why is that?
We chose the third Friday because that is the high point of liquidity for options. There is not an immediate danger, but at some point, there could be too much concentrated roll risk on the last business day of the month. Because these are transparent ETFs, you are announcing the roll date to the world. And so, it gives us also the ability to say we are not with the rest of the market, so we are protected from concentration of that roll risk.
There are also mutual fund versions of these structures which are actually bigger than the biggest ETF versions. And they are rolling on the last business day of the month too. There has been news about the month-end roll now becoming something that market participants are taking advantage of.
I read the study your colleague, Dr. Joanne Hill, published recently on the success major issuers of Buffer ETFs have had at hitting their target outcomes. FT Vest has been very consistent at hitting its targets. Does that have anything to do with the fact that you reset your ETFs on the third Friday of the month?
The third Friday can certainly play a role in that, but I would say it has not thus far. Our ability to hit our targets comes from the way we have structured the portfolios, which is different. And again, now this is all public information. So, some of our competitors have started changing their portfolios to replicate what we do.
We wanted to build a business where we would never fail to hit our target outcomes, because we felt if insurance companies and banks guarantee the outcomes of structured notes and annuities, then that’s the benchmark. That’s the threshold, and we want to make sure we never compromise on that. And so, it’s the structuring of how we put the options together. There is a nuance there, which certainly in the early days was very different from how our competitors did it. Now our competitors are doing the same thing we are, so hopefully across the board any tracking error, however minor, will disappear.
Last question, how are you going to remain one of the leaders in the Buffer ETF space, and how are you going to keep growing market share?
I would say it’s actually an open secret in some ways, it’s by simply listening to advisors. We have an amazing partner in First Trust and that is also their ethos. We listen to the advisors. In our partnership with FT, we collectively hold ourselves accountable to the advisor. We go to advisors, ask, and want to understand them. What are they concerned about in the marketplace today? What are their pain points? What can we do to help them navigate markets better? My belief is that if we stay true to that, keep listening to advisors, keep offering them unique solutions, and become their trusted partner, then I think we’ll maintain or exceed market share.
Thank you, Karan.
Please give us a brief background on Milliman and its risk management strategies.
Milliman has a long history as a respected actuarial consulting firm. Most of that consulting work has been in the insurance industry. We have four different practices: life, health, property and casualty, and employee benefits consulting groups.
I am part of the Financial Risk Management (FRM) group, which is an SEC Registered Investment Advisor, and part of the life consulting practice. We are a group of around two hundred individuals based in Chicago that runs hedging strategies for insurance general accounts, mutual fund sub-accounts for variable annuities, separately managed accounts, UITs, and ETFs as well.
By partnering with Innovator, we are an institutional risk manager that is applying some of these same strategies and techniques to a more retail-friendly ETF wrapper.
And you manage a significant amount of money.
We do. The AUA at the end of 2023 was right around $162 billion.
What is your current role at Milliman and what is your focus?
I am a principal in the FRM practice. I am the head of product development as well as distribution, which oversees marketing and sales support.
Please tell us what a typical day looks like for you.
My day-to-day responsibilities shift as we take on new projects or initiatives. I work quite a bit with onboarding new clients, looking for ways that Milliman can partner with additional asset managers, allocators, insurance companies, family offices, pensions and endowments that may be looking to use risk managed asset management.
I get involved in the strategy design, as well as helping craft the messaging for what can sometimes be considered more complicated stories. I’m also part of our investment committee.
Milliman is the sub-advisor for Innovator’s products. Please explain how you work with Innovator.
I have spent quite a bit of time with Innovator since the early days, working together to create the strategies, marketing, messaging, and we helped create some of the tools they have on their website.
We are sub-advisors and perform trade execution for almost all of the different Innovator defined outcome funds. We also have regular strategy development meetings where we collaborate and share ideas. Most of our work is behind the scenes as they are the ETF sponsor and we’re the sub-advisor.
What does Millman specifically do for Innovator?
We assist with product ideation. So, we have product calls with them on a regular basis to talk through a number of ideas. We always seem to have a dozen or so ideas floating around. And then we have a collaborative discussion about what makes sense to bring to market and where we think there is demand.
Once we get the go-ahead, it comes down to figuring out how to construct the ETF properly to make sure the payoff occurs as designed. When it’s time to launch the fund, we take the seed capital, invest that into the appropriate basket of options, and work with all the different market makers and APs to make that happen. Then there is the ongoing maintenance of the fund, which includes tax management, as well as occasionally assisting with creations and redemptions. We are in constant communication with market makers.
Please explain how the creation and redemption process works with Innovator Buffer ETFs?
Sure. So, creation or redemption of an ETF can be done as a cash create/redeem, meaning the purchaser delivers cash to us. We then go out, working with the APs, and create the new ETF shares that are comprised of a FLEX options basket and deliver that back to the buyer. Since these ETFs utilize FLEX options, it is unlikely that someone would hold the underlying positions already, but if they did, they could also deliver those in exchange for new shares of the ETF. This would be called an in-kind creation.
And, as far as the tax efficiency advantages with ETFs, is that accomplished with in-kind transactions?
Yes. We typically do in-kind transactions with our market-making partners to maintain tax efficiency.
Is the busiest time for Milliman on reset days? And, can you explain what happens on reset day for a Buffer ETF?
Yes, “roll dates” are busy. On reset day, in the afternoon, we know the total asset value of the ETF that’s being reset. We will communicate the amount that is to be rolled over to various APs and market makers. They will come back with their best offer on the basket of options, and then we’ll execute with the one that provides the highest cap for those ETF shareholders.
The underlying liquidity of Buffer ETFs is very good, and that’s because of the liquidity of the FLEX options, correct?
You’re right, but the FLEX options themselves are custom. And so inherently, they don’t typically have a high level of liquidity. These are custom strike prices that vary from standard listed options. The liquidity is really there because we’re using FLEX options that are based on broad indices like the S&P, Nasdaq or Russell. We’re using highly liquid underlying exposures so market makers can very easily hedge and offset that risk. As long as these major indices remain liquid, they can create almost unlimited liquidity in these custom holdings. This is one of the main reasons so many products are built with the underlying exposure being S&P 500, Nasdaq-100, or Russell 2000. FLEX options are cleared through the Options Clearing Corporation.
So, Buffer ETFs are not backed by the credit of a particular institution?
Correct. That is one of the benefits of buying a defined outcome in an ETF wrapper. Because of the structure, you’re not tied to the creditworthiness of an issuing bank or insurance company. The options positions are backed by the OCC, which has been deemed a SIFMU (Systemically Important Financial Market Utility). So, it’s not quite a guarantee, but it is essentially the U.S. government saying that they will not let those institutions fail.
During the financial crisis in 2008-09, and even as recently as the COVID Crash in 2020, can you comment on how the options market functioned during periods of high stress?
In 2008-09, I was trading Treasury futures. So, I was very aware of how the derivatives markets were responding to news of firms like Lehman and Bear Stearns failing. You saw massive swings and spreads in those markets, in both futures and options. So that was an interesting time. More recently, and applicable to Innovator, would be the COVID Crash. That’s as much turmoil as we’ve seen markets exhibit in the past few years while Buffer ETFs existed.
We did see spreads widen a bit on the funds at one point during the day, but then they came back very quickly. Thankfully, in those kinds of markets, shareholders don’t need to trade, which is nice, because there’s no rush to exit. Shareholders have a defined payoff, and they know their buffer level, and the end of the outcome period.
During the COVID Crash, Buffer ETFs held up much better than the broad market.
Yes, they were doing much better than most investors who had unhedged equity exposure. This decreased the pressure on shareholders to exit positions at what could have been the worst time.
Where are you seeing the most demand for Buffer ETF strategies?
There is still significant demand for the basic Buffer ETF structure with the one-year outcome periods. Those original fund structures still garner the majority of new flows.
What is popular in terms of new product discussions now is more focus on income products. We’re seeing a lot of firms looking to try to generate income using option premiums. While that is a clear trend from an issuer standpoint, most of the dollars are still going into the basic Buffer funds, although that may change over time.
Of the various buffer levels offered by Innovator, which level of protection is the most popular?
Within our lineup, it’s definitely the 15% buffer. Investors gravitate towards the 15% level of protection, which they seem to think is the most desirable trade-off. I think most advisors I’ve spoken with are looking at what has the S&P 500 done, on average, in bad years. They ask themselves, how much of the downside am I interested in cutting off in exchange for what portion of the upside in the S&P. With a smaller buffer, you would see a higher cap and vice versa with a larger buffer.
And, are you starting to see increased interest income products?
Yes, those funds have grown quite a bit. They appeal to investors who may think the market’s going to stay pretty flat or in a constrained range. They were also quite popular when interest rates were extremely low. The income products allow you to have some income/growth, that you’ll get without the market having to move much at all. So, if you think we are range bound in the S&P, the income products might make sense.
What about Innovator’s Barrier vs. Buffer Income ETFs?
The barrier products have more downside risk since you assume all losses if the market goes below the barrier, but you’re compensated for that with a higher yield. The buffer income funds always offer some offset to downside risk, but typically have a lower income rate.
Where do you see the defined outcome space headed in the coming years?
I think the growth potential is pretty high. The reality is that these offerings still aren’t available at many larger broker-dealers and wirehouses. If that space opens up more, we could see tremendous growth, which I expect will happen at some point in the next couple years.
Is there anything else you’d like to add that might be of interest to the reader?
I think the only other questions I often get are “What’s the worst-case scenario? How could I be surprised in a negative way by these products?” The most common “surprise” I hear from investors is that the funds may not fully reflect the buffer they thought they were going to get a month or two into an outcome period. Sometimes I’ll get questions from an investor who, for example, invests $1 million, and the market declines a bit and his account statement shows he’s down below $1 million. And, he’ll ask, “Why wasn’t I buffered against the loss?” Investors might not understand that the interim value fluctuates intra-outcome period and can show losses, even if it’s within the buffer range. So, they need to clearly understand that the defined outcome is over the full outcome period beginning on the reset date.
The other potential area of misunderstanding is that if you don’t buy these funds around the reset date, you’re taking on some additional upside or downside exposure by buying funds above or below the starting point. Investors need to understand the exact outcome parameters at the time they are buying.
Thank you, Wes.
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 investors choose to trade the options on their 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. 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 and launched 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.