How much would you pay for insurance that immunizes your stock portfolio from losses?
A just-launched exchange-traded fund in effect asks you that question. It is the Innovator Equity Defined Protection ETF
Many investors, but especially retirees and near-retirees who have less time to recover from bear markets, are intrigued.
Is this new ETF a good deal? There are two major factors you should take into account when deciding whether this ETF is appropriate.
There’s more than one way to skin a cat
The first thing to keep in mind is that there’s more than one way of duplicating the ETF’s approach. The core idea is to invest your portfolio in U.S. Treasurys and use the interest to purchase call options on the S&P 500. The maturity date of the bonds and expiration date of the options would be the same, and would reflect whatever time horizon over which you want to be protected from any losses.
The approach is simple enough that you can do it yourself with relatively effort, thereby saving yourself the expenses of having someone else do it for you. This new ETF has an expense ratio of 0.79%, for example.
To illustrate, you could invest approximately 91.5% of your equity portfolio in 2-year Treasurys and the remaining 8.5% in a two-year in-the-money call option on the S&P 500. You hold until the bonds mature and the call expires, and then do it all over again.
The 91.5% bond allocation in my illustration is a function of 2-year Treasurys’ yield, which currently is 4.74%. At that rate, your bond plus accrued interest will in two years’ time be equal to 100% of your portfolio’s starting value. And if the S&P 500 is sufficiently higher at the end of that period, your call option will show a profit as well. Voilà, you have a portfolio that participates in the stock market’s upside potential and is guaranteed not to lose money.
This do-it-yourself approach is not an exact replica of this new ETF, which promises 100% of the S&P 500’s return up to the 16.62% cap. The do-it-yourself approach, in contrast, only produces a profit if the S&P 500 gains more than the cost of the call option. But there is no upside limit to that profit.
Regardless of whether you invest with the ETF or the do-it-yourself approach, however, your profit potential is heavily dependent on interest rates. When the 2-year Treasury yield in 2020 stood at just 0.11%, for example, this Treasurys-plus-call-options approach would have been unable to participate in any significant portion of the stock market’s gains. This new ETF is a lot more attractive now than it would have been in 2020.
This in turn means there is no guarantee that the approach will have similar potential in two years’ time when your Treasurys mature and your call option expires. This new ETF’s terms apply only to the two-year period that began earlier this week.
There’s another way of duplicating the approach of this ETF: A fixed-index annuity (FIA). Currently, I was told by Adam Hyers of Hyers and Associates, an independent annuity brokerage, you can invest in a five-year FIA with a two-year reset period over which you have complete downside protection and can earn the S&P 500’s price-only return up to a maximum of 19.75%. This rate applies when investing at least $100,000; for amounts between $25,000 and $100,000, the profit cap is 17.75%. There are 10-year FIAs benchmarked to the S&P 500 with caps as high as 21.0% with a two-year reset period.
You forfeit a lot of upside potential with any of these approaches
The second factor you should consider when deciding whether this new ETF is appropriate is that the ETF gives up a lot of upside potential in order to protect you from any losses. The same is true of the do-it-yourself approach and the fixed-index annuity.
Calculating the hypothetical historical return of this new ETF is quite complicated, since it’s impossible to know what cap on S&P 500 profits the ETF would have imposed in prior two-year periods. For a back-of-the-envelope calculation, I assumed that the ETF’s 16.62% cap existed in every prior period as well. As you can see from the table below, on this assumption the ETF’s hypothetical annualized return would have been barely half that of the S&P 500’s since 1929. It also would have significantly lagged a 60% stock/40% bond portfolio.
|Annualized return 1929 through 2022|
|Strategy that earns the S&P 500’s price-only profit over every two-year period, subject to a 16.62% cap, and stays even in the event the S&P 500 declines over that period||5.0%|
|S&P 500’s total return||9.4%|
|Portfolio 60% stocks/40% long-term Treasurys||8.2%|
One reason this hypothetical ETF’s return is so much lower than buying and holding is the big role played by dividends. The S&P 500 gain that the ETF participates in is price-only, and dividends have accounted for nearly half of the S&P 500’s long-term return.
The overall investment lesson I draw from this discussion is that the markets do an impressive job balancing risk and reward. If you want to reduce your risk, you will have to give up some expected profit in return.
There is no free lunch.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at email@example.com