The marketplace for exchange-traded funds (ETFs) grows each day, and more and more different and innovative products are being created. One new type utilizes derivatives. A derivative is a financial object that derives its value from an underlying financial security. An example of this is what is called an option. An option is a contract between two parties that gives the buyer the choice to buy or sell a security at a predetermined fixed price. The original purpose for options was to balance risk in a concentrated portfolio. You could hedge a bet by securing a selling price or buying price of a stock. Nowadays, some ETFs are using derivatives for very different purposes, such as increasing their exposure (levered ETFs) or setting a buffer on the equity returns (defined-outcome ETFs). While these ETFs are innovative and flashy, it’s important to think about the ramifications of investing in such a product.
A levered ETF uses either derivatives or borrowed capital to increase exposure to the underlying assets (e.g., stocks). This increase is a double-edged sword. Not only are the ups larger but the downs are larger as well. In a portfolio, the increase in the drawdowns makes the leverage ineffective for increasing risk-adjusted returns, unless paired with volatility or drawdown-reducing strategies such as trend following. In March of 2020, the S&P 500 Index fell by -12.5%. For a theoretical 2x levered portfolio, the drawdown would have been -25%. An unlevered portfolio would need a return
of 14.3% to get back to breakeven. A 2x levered portfolio would need a return of 33.3% to get back to breakeven. Astute readers will notice that 33.3% is MORE than double 14.3%. This simple aspect of leverage is one of the many reasons it should be taken on with caution. Successful investing is often more about not losing than it is about winning.
These ETFs offer certain upsides and downsides. These upsides and downsides are calculated for the lifetime of these funds. Depending on when the investor buys into the fund, they could experience a very different return, including one outside of the promised range. This limitation can particularly be a problem if the market increased prior to the purchase, as the upside return at that point can be severely capped. The forward-looking return of these products decreases exponentially as the market increases.
Levered ETFs also suffer from underperformance compared to their benchmark. This drag comes from the imperfect way that leverage is acquired either through derivatives or borrowed capital. Out of 22 standard levered ETFs in the market today, every single one of them has underperformed their prospectus benchmark when the same amount of leverage was provided for the past five years. We believe this underperformance, when combined with the issue of large drawdowns, high tax costs due to inefficiency of derivatives, and high fees, makes these levered ETFs ill-advised as long-term investments.
Another new instrument that has captured the attention of many is the so-called “buffer ETF.” Buffer ETFs advertise guaranteed returns in a specific range. While these products offer a solution to specific problems, like the levered ETFs, we believe they are an ill-advised investment for long-term investors looking to grow their principal or provide income in retirement.
The biggest drawback of buffered ETFs is that investors pay too much for the downside protection that they receive.
The most widely held products advertise options for reducing annual downside risk by 9%, 15%, or 30%. In return, the investor relinquishes upside growth.
The plot below shows how the annual return distribution of a buffered approach compares to the return of the underlying index. The index is represented by the historical annual returns of the S&P 500 minus 0.05% which is an estimated cost for a low cost S&P 500 index fund. The buffered approach simulates applying a 9% reduction in downside risk and capping the upside at 15%. It is intended to be representative of the types of products currently on the market. It also includes a 0.75% reduction to simulate the fees associated with typical defined-outcome products.
The plot shows clearly that while the buffering provides some downside protection in large drawdown years, there have been very few of those historically. Let’s see how this affects an investor’s outcome in some real-life scenarios.
For the years 2017, 2018, and 2019, the S&P 500 has returned 22%, -4%, and 32%. A 13% buffer ETF would have reduced the cumulative 53% gain to an approximate 25% gain. When we apply this same methodology of a 15% top buffer and a -9% bottom buffer to the S&P 500 since 1928 (94 years) on an annual basis, we get a stark difference in returns. During the 94 years surveyed, the S&P 500 index minus an average index fund expense ratio (“Net S&P 500 Index”- see important disclosures regarding these calculations below) had an annualized return of 10.2%, while a the model for a rolling buffer ETF on the S&P 500 Index starting January 1st would have a return of 6.1%. To further illustrate this point, for example, start with $100,000 and invest it for 25 years, and at these annualized rates of return an investor may see the Net S&P 500 Index outperform the rolling buffer ETF model by $600,000. This underperformance can seriously affect the probability of successfully reaching one’s goals.
While an investor is buying drawdown protection by using a buffer ETF on a 5-year timescale since 1928 this has only yielded better returns 18% of the time as compared to utilizing alternative vehicles in seeking to protect against downside risk. Historically, a more efficient and higher return way of decreasing downside risk is using fixed income solutions such as treasury bonds. By way of an example utilizing the historical data described above, if an investor used 20% of the portfolio allocated to 5-year treasury bonds and the rest to the S&P 500 index model referenced above, the investor has reduced the historical possibility of underperformance to 13% and will maintain, pursuant to the historical data, a return that’s over 3% of the buffer ETF model. When done with multiple types of fixed income and alternative asset classes such as reinsurance or alternative lending the probability of underperformance continues to decrease. Do take note that the return and underperformance possibilities are based upon historical performance data and, therefore, future performance is in no way guaranteed and may be subject to wide variances due to unforeseen market, economic and other conditions. Peace of mind is something we all seek. In many cases, purchasing insurance to guard against risks one can’t control is an excellent choice. However, if the premium you pay is greater than the insurance you receive, it doesn’t make financial sense.
The bottom line for most of these derivative investments is that while they seem very attractive on the surface, once you look at the mechanics and nuances, they turn out to be ineffective at generating the solid risk-adjusted returns most investors need and want to meet their financial goals.
IMPORTANT DISCLOSURE AND DATA INFORMATION
The distribution graph is for illustrative purposes only, and is not intended to serve as personalized tax and/or investment advice since the availability and effectiveness of any strategy is dependent upon your individual facts and circumstances. The information portrayed in these materials represents model performance and characteristics for the Merriman Model S&P 500 Index Fund or the Buffered S&P 500 and may not reflect the impact that material economic and market factors may have had on the adviser’s decision making. The make-up of any actual advisory program portfolio may differ as compared to the model portfolio provided herein, and is not meant to be representative of any one client or portfolio. In addition, the actual results of any of the adviser’s client portfolios may have been, or may be, materially different than the results of the hypothetical portfolio set forth herein. Market conditions, client restrictions, world events and any other macro variables may have a substantial impact on any of the adviser’s advisory program portfolios. The performance information does include the deduction of advisory fees and execution related fees, except custodial fees. To determine the Net S&P 500 Index, the average expense ratio used was determined by taking three of the largest and most liquid S&P 500 Index ETFs and averaging their fee. (IVV @ 0.04%, VOO @ 0.03%, and SPY @ 0.0945%) This averaged to 0.058% and then rounded down to 0.05% for ease of use and due to industry wide fee compression. The performance information does reflect the reinvestment of dividends and earnings. The information used for S&P 500 columns is based on historical index returns from 1928-2019. The information used for the “buffered” column is based on simulated data as described in the article. All data calculations are available upon request.
The information provided should not be considered a recommendation to purchase or sell any industry, sector or particular security. There is no assurance that any industry, sector or security discussed herein will remain in a client’s account at the time of reading this material or that any industry, sectors or securities sold have not been repurchased. The industries, sectors or securities discussed herein do not represent a client’s entire account and in the aggregate may only represent a small percentage of an account’s holdings. It should not be assumed that any of the securities, transactions or holdings discussed were, or will prove to be profitable, or that investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein. All investing entails the risk of loss.
The S&P 500 index includes 500 leading companies in the US and is widely regarded as the best single gauge of large-cap US equities. Any reference to an index is included for illustrative purposes only, as an index is not a security in which an investment can be made. Indices are unmanaged vehicles that serve as market indicators and do not account for the deduction of management fees and/or transaction costs generally associated with investable products. The holdings and performance of Merriman client accounts may vary widely from those of the presented indices. Advisory services are only offered to clients or prospective clients where Merriman and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Merriman Wealth Management unless a client service agreement is in place.
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As a Research Analyst, Lev works to improve Merriman’s core investment solutions using an evidenced based approach. Lev spends his days researching specific topics, performing custom client analyses, preparing client materials and improving automated systems. Before joining Merriman, Lev gained experience at Parametric Portfolio Associates a quantitative asset management firm.
Lev has a bachelor’s degree from the University of Washington where he studied physics and astronomy. While at UW Lev competed in pole vault and is still active in the community around Seattle, coaching at high schools and local camps.
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