Investors have caught a reprieve so far this year. The S&P 500 has been delivering solid gains, while overseas stocks have offered a boon to globally diversified portfolios. The bond market has also caught a bit on growing fears of a U.S. recession. Yields have dropped from their highs notched earlier in 2023, but the Federal Reserve (Fed) remains as motivated as ever to bring inflation down to its target near 2% sooner rather than later. 

Still, the psychological wounds inflicted by the stock and bond market drubbings of 2022 will be long lasting. Retail investors will now see the bond sleeve of their allocation as risky, just as they do the equities portion. Similar to what happened after the 2008 Great Financial Crisis (GFC) — recency bias and the saliency of seeing substantial losses leave an indelible mark. In the wake of the GFC, it was common to seek alternative investments that could weather any future economic storms better.

Downside Protection Done the Right Way with Halo

At Halo, it is our mission to keep investors in the game, but in a risk-conscious way. We don’t believe that wholesale portfolio changes are necessary after 2022. Rather, diversification and downside protection can be achieved without adding high-cost alternative investments or ones that are so complex even an experienced financial advisor would have a difficult time explaining them to their clients. 

Structured notes, annuities, and buffered ETFs are intended to improve investment outcomes for a range of clients based on their different risk tolerances and return objectives. What’s more, technology and competition have brought down costs over the years and decades. Now, everyday investors can own a protective investment through the ETF wrapper for tax efficiency and easy tradeability. 

What’s Hot on the Street?

So, what’s the popular new trade on Wall Street to guard against volatility and offer a cushion to the ever-present risk of a bear market? ETFs with juicy yields that purport to produce alpha during equity market downturns. You have likely heard of two of the leading products in this space, but we offer a third choice that may be a better fit for your clients. Let’s outline the products and their use cases.

• JPM Equity Premium Income ETF (JEPI)

Flip on CNBC, and you will surely see the JEPI ticker scroll across the bottom of the screen. This fund, launched in May 2020, sports a high 11.3% trailing 12-month dividend yield and is priced at a 0.35% annual expense ratio. Its name is fancy, and the strategy may sound complicated, but it is straightforward if you understand the derivatives market. JEPI generally holds low-volatility stocks in its value-based style construction. The S&P 500 Index is the ETF’s benchmark, but it strays from the bench by selling options on large-cap U.S. stocks, then investing the proceeds from those sales. 

JEPI set the annual record for active ETF inflows last year with more than $12 billion, according to Eric Balchunas at Bloomberg. The previous record was the ARK Innovation ETF (ARKK), which gathered $9.5 billion in 2020. For context, JEPI’s assets under management first hit $1 billion in April 2021, so growth has been off the charts. Daily volume of the product has been on the rise as well. About 10 million shares exchanged hands daily on several occasions earlier this year. Even as markets recover some losses, there’s clearly a desire for protection through a fund like JEPI.

• NASDAQ 100 Covered Call ETF (QYLD)

In a similar vein, tech investors concerned about near-term declines flock to QYLD. This ETF engages in covered-call writing to generate income. Like JEPI, it should produce outperformance when volatility strikes and equities move lower. QYLD sets investors back a bit more annually, though — its expense ratio is 0.60%, while assets under management (AUM) sum to more than $7 billion. Average daily volume is nearly 7 million shares, while its distribution yield hovers just under 12%. As volatility wanes in the tech space, the ETF collects less income compared to the high-volatility of last year. 

Popular, but Cookie Cutter

The potential issue with these covered-call writing ETFs is that they are one-size-fits-all solutions. Also consider that retail investors may park money in these funds for their alluring yield, not recognizing that they will almost certainly lose out to broad index funds over the long haul. An advisor must always work with clients to ensure products like JEPI and QYLD are the right fit at the right time.

Buffered ETFs Through Halo

Buffered ETFs can be a better solution. Consider that these funds pinpoint the ideal amount of growth and protection. You can build resilient portfolios and build confidence with clients. How so? You know what you are getting into. Covered-call funds do not feature defined outcomes. Even if you generate some income to offset losses in the broad market, downside risk can be extreme. With buffered ETFs, the investor can have confidence in knowing what their range of returns will be under certain market conditions. According to ETF.com, there are now more than 160 buffered ETFs with more than $23 billion in net assets.

What’s a Buffered ETF?

This type of fund is thought of as a structured ETF in that it essentially replicates the payout profile of a structured note in the ETF wrapper. Buffered funds track the performance of a specific index, seek to provide a level of downside protection, participate in the upside of the benchmark index up to a certain point (called the “cap”), and have a future maturity date (commonly 12 months).

Buffered ETFs use FLEX options to construct the desired return payoff, with a long call option bought on the benchmark index. Then the issuer purchases puts based on the maturity date, while selling lower strike puts to help finance the trade. Finally, a call option is sold on the reference index, capping potential returns. In the end, the return an investor earns is based on the period over which the fund was held, the index’s performance (not including dividends), and the terms of the FLEX options at the onset of the outcome period.

Exchanging Return for Reduced Loss Potential

The upshot is that, with more buffered ETF strategies, the upside return is capped to a predefined percentage, while there is a downside “buffer” against losses on the index. For instance, if the benchmark is down 25% in a year, then the ETF might only be down 15%. Buffered ETFs trade on the open market and feature a fluctuating price and net asset value (NAV), so being aware of the remaining cap, remaining buffer, and remaining loss to the buffer are three key metrics to watch. 

A Hands-Off Approach

On the maturity date, the ETF issuer will simply roll into new options contracts with the same maturity length and buffer levels, but with a new upside cap. That way, the investor or advisor does not have to switch funds — a key benefit of the ETF wrapper, along with possible tax advantages compared to the DIY approach.

Who’s It For? Primarily Risk-Averse Investors

At Halo, we find that advisors used buffered funds to reduce clients’ overall portfolio volatility, while putting excess cash to work in a diversified and risk-controlled way. Defined-outcome investments help clients — especially those nearing or in retirement — have more confidence in their allocation. 

Growth Ahead: A Big Player Enters the Space

And even with higher interest rates in the bond market today, there is growing interest in the buffered ETF space. In April 2023, the world’s biggest ETF issuer announced that it planned to introduce a set of buffered ETFs. We encourage advisors with whom we team to consider this type of protective investment strategy, but priority one is ensuring a given fund matches the risk/return characteristics of the client. 

The Bottom Line

The popularity of buffered ETFs and other risk-reduction strategies continues to grow despite the rebound across markets in the last several months. Advisors must educate clients about the array of viable solutions in today’s marketplace, and Halo’s suite of buffered funds can be a solution to help individual investors stick with a long-term investment strategy.