The buffered ETF sector has increased in popularity (assets under management has grown to more than $12 billion), and innovation within the category is rising as well. One example is ETFs that provide double or triple an index return, while only participating in downside on a one-to-one basis. For example, if the S&P 500 (SPY) or Nasdaq 100 (QQQ) rises 5%, a corresponding type of this ETF would return 10% or 15%. If the related index fell 5%, the ETF would fall 5%. These types of ETFs allow us to capture 2-3 times as much upside, without increasing any of our downside. Before proceeding further, if you haven’t yet read our introduction to buffered ETFs, we recommend doing so.
QQQ vs QTAP: a case study
In late July, we started allocating to one of these types of ETFs: QTAP. The QTAP ETF offered 3 times the return of the Nasdaq 100 (via QQQ), up to a 21% cap for the period from April 1, 2021-March 31, 2022 (the outcome period). In order for QTAP to return 21%, QQQ needed to rise by 7% during the outcome period. At the time of our QTAP purchases, which came four months into the outcome period, QQQ was up 14% QTAP was up 11%.
Due to the 3X return profile of QTAP, the +14% return for QQQ as of July 30th meant that QTAP would rise an additional 10%, (from 11% to its 21% cap), if QQQ did nothing through the rest of the outcome period. Not only that, but QTAP would still return the additional 10% even if QQQ fell 6% from July 30, 2021-March 31, 2022. That’s because QQQ’s 14% return at the time was above the 7% return needed for QTAP to reach its full 21% cap (7% * 3 = 21%).
The results of our QTAP investment
From there, we turned the return profile into a question: from July 30, 2021-March 31, 2022 (8 months), did we view QQQ (or any major index) returning more than 10% as a high probability? Our answer was no, so if we were right, QTAP would outperform the market over the next 8 months. Here’s the results from the time of our purchase on July 30th:
Even though QQQ fell 0.30% from July 30, 2021-March 31st, 2022, QTAP still rose nearly 9%. This is because QQQ’s return was still above the 7% return needed to reach the 21% cap. The reason QTAP’s return wasn’t the full 21% is because it has a 0.71% expense ratio. All told, QTAP out performed QQQ by nearly 7% during its outcome period and by more than 9% during our personal holding period. Furthermore, QTAP was less volatile than QQQ, which fell more than 20% from its November 2021 high. For comparison, QTAP’s largest pullback during the period was roughly 13%.
Trading details & what’s next
QTAP’s outcome period reset on April 1st and it got a new cap level and started tracking QQQ downside one-to-one again (see this education center for more info on key terms). This shifted the return profile quite a bit because we were no longer playing from ahead like we were when we first bought in July. As a result we started to reduce our allocation as the end of the outcome period approached.
At the time of our sales, our total exposure represented as much as 5% of the fund’s assets under management. Importantly, we had zero issues executing sales. QTAP’s market price was exactly where we expected it to be based on the QQQ.
In a number of accounts that held QTAP, proceeds from sales were rolled into a similar ETF, XTJL. The difference between QTAP and XTJL is that XTJL is tied to the S&P 500 (via SPY) and not the Nasdaq 100 (QQQ). The other key difference is that XTJL’s outcome period runs from July 1, 2021-June 30, 2022. If between now and June 30th, SPY can rise 2.50%, XTJL will return nearly 8%, which would represent outperformance of 5%:
In order for SPY to out perform the maximum potential return of XTJL through June 30th, SPY would need to rise to $472.38. We don’t view that as a high probability outcome. To the downside, there are risks with XTJL. Because the fund returns 3 times SPY’s performance for the outcome period (July 1, 2021-June 30, 2022), it is currently up 5.60% (compared to 2.60% for SPY over the same time). Therefore, if SPY were to give back that 2.60% gain by June 30th, XTJL would be expected to also give back the 5.60% gain it currently has. Thus, XTJL could fall 3% more than SPY between now and the end of the outcome period.
Balancing risk versus reward
Products like QTAP and XTJL are not suitable for everyone. But these products are tools that can offer attractive risk versus reward opportunities. For instance, we were able to generate positive returns in QTAP over the last 8 months, even though broader markets fell or were flat. Also, because a product like XTJL has a different outcome period than QTAP (July-June versus April-March), there is built in flexibility in being able to switch strategies based on whichever ETF offers the most suitable risk and reward. As usual, there is no one-size-fits-all approach, but we’ll continue to lean on ETFs like these where appropriate.
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