Buffered ETFs are most known for protecting downside exposure in the stock market while allowing for upside participation as well. However, as buffered ETFs become more broadly adopted other use cases are popping up. One of them is for deep in the money buffered ETFs to act as quasi fixed income ETFs. Allow me to explain…
Buffered ETFs explained
The best way to think about buffered ETFs is as a contract tied to an index’s performance, such as the S&P 500 or NASDAQ-100. The contract states the buffered ETF will protect shareholders against the first 10% decline in the index over a defined outcome period, typically 12 months. In exchange for this protection, the buffered ETF will only participate in the first 10% rise in the index over the same period. These types of ETFs are valuable in that they offer a “heads I win, tails I don’t really lose” type of investment strategy. If the index declines 10% in the next year, the buffered ETF will finish the period flat. If the index rises 10%, the buffered ETF will increase by 10%.
In our view, these types of products offer nice propositions. So you might be asking, what’s the catch? Well, in a roaring bull market, buffered ETFs will underperform the index. Remember, the buffered ETF is protecting you in exchange for capping your reward. So if the index rises much higher than the cap, then there’s a lot of opportunity cost in owning the buffered ETF versus owning the index itself. In fact, this exact scenario is playing out right now for a number of buffered ETFs that launched on April 1st with 12-month outcome periods.
The big rally started in April
The stock market bottomed out in late March and has risen sharply since; the S&P 500 is up more than 50% from the bottom and more than 30% since April 1st. The Nasdaq-100 has been even stronger, rising more than 65% since the bottom and 50% since April 1st. The effect on buffered ETFs that started trading on April 1st, with an outcome period of 12 months (3/31/20-3/31/21), is that they are all underperforming the indices. NAPR, for instance, is a buffered ETF linked to the Nasdaq-100. NAPR offered a buffer against the 15% of losses in the Nasdaq-100 in exchange for only participating in the first 15% gains in the same index.
Like we just mentioned, the Nasdaq-100 is currently up 50% since April 1st. So at a 15% cap on gains, NAPR is trailing the index, which could have been bought directly via the QQQ ETF, by 35%! That’s a lot of opportunity cost if you’ve owned NAPR instead of QQQ since April 1st. But if you haven’t, it presents a current opportunity. How so? Well, NAPR is currently up 12.32% since April 1st versus its full capped return of 15%. Meaning, there’s still 2.68% to go before NAPR reaches its capped return. And the probability of NAPR rising 2.68% is very high. Let’s dive a little deeper to understand why.
Why hasn’t NAPR reached its cap?
First, let’s address this question: if the index NAPR is tied to, the Nasdaq-100, is up 50%, then how come NAPR hasn’t yet risen all the way up to its 15% cap level? The answer is time. There is still time between now and the end of outcome period, because remember, buffered ETFs are essentially tradable contracts that cover 1-year time periods. In NAPR’s case, the time period, or outcome period, isn’t until March 31st, 2021. That’s still more than 5 months away. Therefore, the price of NAPR still reflects the possibility of what could go wrong between now and March 31st, 2021.
It’s entirely possible, though not very likely, that the Nasdaq 100 will decline 25% between now and March 31st, 2021. Such a decline would bring the Nasdaq 100 back within the original range of NAPR’s capped gain. This time value is reflected in the price of NAPR, and it changes depending on how close or far away we are from the end of the outcome period. Consider that, on September 2nd the Nasdaq-100 was 6% higher than it is right now, yet NAPR’s remaining cap was still right around 2.30%, like it is now. The reason that the index can be lower now but the remaining cap can still be around 2.30% is that the time value has decreased. The decrease in time value offset the decline in the index’s price.
Fixed-income like opportunities
As the end of the outcome period for NAPR (3/31/2021) gets closer and closer, time value will decrease more and more. With time value decreasing every day moving forward, the only thing that will stop NAPR from rising up to its 15% cap is a sharp decline the Nasdaq-100. In fact, as the table below shows, the Nasdaq-100 could decline 20% between now and March 31, 2021, and NAPR would still be expected to rise more than 2%:
The reason we call these quasi fixed-income opportunities is because the returns are fixed under a number of different scenarios. In addition, they’re relatively safe. Based on current pricing in the options market, there is only a 13% chance that the Nasdaq-100 will be below the 15% return threshold that would eat into NAPR’s remaining capped return by March 31, 2021. Turning that around gives us an 87% chance of achieving a 2%+ return between now and then. We think those are good odds that are worth the risk. Especially when you consider that the risk-free rate of return, as measured by a 6-month treasury bill, is currently 0.12%. By taking a little more risk with a buffered ETF like NAPR, we can lock in a return that is nearly 20x higher than the risk free rate.
Who NAPR is good for
When we think quantitatively about measuring risk versus reward, these are the types of risks that make a lot of sense to us. The important thing is to understand why you would own NAPR instead of a non-buffered ETF like QQQ. We’ve heard from many clients who have seen their high yield savings bank rates drop from more than 2% to now less than 0.80%, and in some cases as low as 0.40%. While NAPR will not provide cash flow, it does offer a high probability at a fixed-rate of return in the near future.
Here are some final considerations:
- NAPR, and the market for buffered ETFs in general, is less liquid than regular index ETFs like QQQ. Therefore, using limit orders is very important.
- The price of NAPR will continue to fluctuate over the next few months due to time value and price changes in the linked index, the Nasdaq-100.
- You can monitor changes in NAPR’s return profile here.
Remember, there is no free lunch in the market. All I have done in this article is outline a calculated risk-reward opportunity that may be appropriate for certain investors. We don’t use buffered ETFs instead of normal ETFs, but rather as a complement to or replacement for select allocations. Given the current low-interest rate environment, investors are forced to think outside of the box when it comes to fixed-income allocations. And buffered ETFs like NAPR could be a good place to look. If you’d like to learn more about how to incorporate buffered ETFs into your portfolio, schedule an online meeting with us.
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