Investors nearing or in retirement often face the challenge of balancing their aversion to short-term losses with the need to maintain exposure to growth assets to meet long-term goals. Traditionally, portfolio managers have used a mix of equities and less volatile assets like bonds to dampen portfolio swings while retaining at least some of equities’ upside potential.
However, even stock-bond portfolios still carry some risk of loss, at least in the short term, which can rattle investors who are sensitive to declines in their investments’ value. Fixed income doesn’t experience the same kind of drawdowns as equity during periods of market volatility, but most bonds and bond funds can still lose value (other than individual Treasury bonds, whose principal is guaranteed by the U.S. government). Furthermore, while bonds and equities have been negatively correlated for much of the 21st century – offering portfolios a natural buffer with bonds experiencing positive returns when equities go negative and vice versa – the correlation has flipped to positive in recent years, increasing the chances that all parts of an investor’s portfolio are in the negative at once – making it even more psychologically difficult for investors to stay the course during periods of volatility.
One increasingly popular response has been the rise of ‘defined outcome’ ETFs, which use structured derivative strategies like option collars to set boundaries around both downside risk and upside return. Among these, ‘downside protection’ ETFs have gained attention for their promise of protecting investors from loss while offering some equity market participation, typically capping positive returns at a given rate (currently around 7%). Compared with similar alternatives like Fixed Income Annuities (FIAs) or DIY option collars, downside protection ETFs are often more liquid, scalable, and tax-efficient, giving them a powerful sales pitch to risk-averse investors.
However, a closer look at the mechanics of the funds currently on the market uncovers traits that undercut the sales pitch. Because the ETFs are based on option strategies with specific beginning and end dates, their stated upside and downside limits are only fully available to investors who buy them at the very beginning of the cycle. Within the year, prices can still fluctuate, meaning the promised psychological comfort only holds if investors don’t look at their account value throughout the year!
The promise of ‘equity participation’ is also more limited than it appears. With performance caps currently in the 6–7% range, downside protection ETFs lag equity returns in most historical rolling one-year periods. Investors who buy mid-cycle may even see losses relative to their entry price, despite the ‘no loss’ marketing. And unlike bonds or Treasuries, which offer guaranteed income and principal preservation, downside protection ETFs can deliver flat or even negative real returns after fees if markets are flat or slightly down.
Ultimately, downside protection ETFs can serve a niche purpose, such as holding short-term funds earmarked for near-term goals where principal protection is critical and the investor is comfortable sacrificing upside. But they are not a true substitute for equity exposure, and their complexity can mask the relatively modest benefits they offer compared to more traditional fixed income strategies. For advisors, the deeper value lies not in outsourcing risk management to a product, but in reinforcing disciplined investment management and behavioral coaching. By helping clients stay invested through market volatility – armed with a long-term perspective and a thoughtfully constructed portfolio – advisors can deliver not only better outcomes but also greater peace of mind than a ‘defined outcome’ ETF can promise.
Read More…
-1024x683.jpg "Florida Roads Become a Battleground for Illegal Immigration")
