As we learned in an earlier chapter, the cost of the first 5% downside protection with Buffer ETFs is expensive. In order for Innovator and First Trust to offer deep buffers with an attractive upside cap, investors have had to forgo protection on the first 5% loss during the outcome period. Unfortunately, this isn’t all that appealing to investors who prefer total downside protection to a certain buffer level. Can you construct a deep buffer portfolio without giving up protection on the first 5% loss? Absolutely.
Here’s a creative way to allocate a portfolio to protect against the first 5% loss, all the way down to -30% or -35%, depending on how much downside protection you want. Being able to protect to a decline of 35% will shield your portfolio in pretty much any market meltdown scenario other than a severe market crash, where losses could hit 50% or more, peak-to-valley.
Let’s assume you have a $1 million portfolio. By dividing your portfolio evenly between a 3-month Treasury bill and a Deep or Ultra Buffer ETF, you can effectively cover the first 5% loss on the entire portfolio, down to -30% or -35%, while also having attractive upside potential with half your portfolio.
Let’s look at how your portfolio could be constructed with some hypothetical return scenarios.
Portfolio Allocation: 50% Treasury Bills & 50% Ultra Buffer ETFs
50%: Purchase 3-month Treasury bills (current yield is approximately 5.4% annualized).
50%: Purchase Innovator’s Ultra Buffer ETF (UJAN – January 2024) on the reset date.
On its recent reset date, UJAN offered downside protection from -5% to -35% over a 12-month outcome period while offering a gross cap of approximately 14%. This is a pretty nice potential 12-month return, but you might not want to give up protection on the first 5% loss.
With $500,000 allocated in a Treasury bill, and you roll it every three months (assuming the yield stays above 5% for the full outcome period), you could effectively cover the potential 5% loss on the Ultra Buffer ETF. If the reference asset (SPY) shows a 5% loss during the outcome period, but not more than -35%, the total return for the portfolio would be flat (slightly positive at $2,000 at the current Treasury bill rate). This is not a bad outcome if the stock market has tumbled.
Down-Market Scenario
Let’s assume the stock market declines 30% during the outcome period. This would obviously not affect the return of the Treasury bills, so over the outcome period, the Treasury bills would earn $27,000. Again, this assumes the 3-month Treasury bill earns 5.4% annualized (rolled every quarter to a new T-bill) during the outcome period, and earns the same percentage return for the full 12 months.
UJAN, which provides deep protection to -35%, but does not provide protection on the first 5% loss, would have lost $25,000 or 5%, if the reference asset (SPY) declined 30%. So, UJAN would show an unrealized loss of $25,000 at the end of the outcome period.
The return for the total portfolio (before fees) would be flat – a slight gain of $2,000 (the dollar difference between the loss on UJAN and the gain on the Treasury bill position).
Here’s the return breakdown of the total portfolio in this hypothetical down-market scenario (before fees):
Treasury bill return: 5.4% on $500,000 = $27,000
UJAN return: -5.0% on $500,000 = -$25,000
Total return: $2,000 or 0.20%
Up-Market Scenario
Now, let’s assume the stock market has a strong 12-month period following your purchase of the Treasury bills and UJAN on its reset date. UJAN had a gross upside cap of approximately 14% during the outcome period.
Over the outcome period, the Treasury bills would not be affected whatsoever by the returns (up or down) of the reference asset (SPY), so the return on the Treasury bills would have been the same as in the down-market scenario: $27,000, assuming a 5.4% annualized return.
Let’s assume the stock market was in a strong uptrend and gained 20% during the outcome period. UJAN was capped at a gross percentage gain of 14%, so the investor basically forfeited the gain beyond 14% during the outcome period. Still, UJAN provided the investor with a nice return of 14%.
Here’s the return of the total portfolio in this hypothetical up-market scenario (before fees):
Treasury bill return: 5.4% on $500,000 = $27,000
UJAN return: 14% on $500,000 = $70,000
Total return: $97,000 or 9.7%.
This hypothetical up-market scenario allowed the investor to nearly double the return that would have been earned by a portfolio 100% allocated in Treasury bills. And, with deep downside protection, a conservative investor should have had a high level of comfort and peace of mind knowing there was protection on the total portfolio, even if the stock market dropped 35% at the end of the outcome period.
There are many ways to creatively allocate a portfolio to obtain a desired level of downside protection beyond what is offered by the major issuers of Buffer ETFs.