Buffered ETFs have played an important role in our portfolios throughout the year. We were less optimistic coming into the year, (not to be confused with bearish), and the protective nature of buffered ETFs appealed to us. If you’re not familiar with how buffered ETFs work, we encourage you to review this article. The basic premise is they provide profit potential up to a “cap,” in exchange for protection against losses down to a “buffer.” This cap and buffer are in effect over 12 months or the “outcome period.” In this article, we’ll breakdown an intriguing opportunity in PAPR, Innovator’s April 15% Buffered ETF.
April got off to a hot start
PAPR’s new outcome started on April 1st and lasts until March 31, 2021. The ETF has a 14.61% cap (net of fees) and a 14.21 buffer (net of fees). These levels are based on a starting price in the S&P 500 of 2584. Therefore, PAPR will participate in gains up to the 2962 level in the S&P 500 (14.61% above 2584). And it will participate in losses after the S&P 500 breaches below the 2217 level (14.21% below 2584). Now, since the new outcome period began, the S&P 500 has rallied 18% to 3055 (as of 6/1/20), yet PAPR is only up 7.70%. Why hasn’t PAPR gone up 14.61% given that the S&P 500 is already above the cap level? Because there are still 10 months left until the end of the outcome period.
There is time value built into the structure of buffered ETFs like PAPR. Therefore, the ETF will lag behind its index the farther it is away from the end of the outcome period. As the end of the outcome period draws closer, the time value decreases. As the time value decreases the performance of the ETF will start to track the performance of its index more closely (within the range of its cap or buffer). So in this case, if the S&P 500 is still above 2962 at the end of March 2021, PAPR will rise an additional 6.90% (current return of 7.70% + 6.90% = 14.61% capped return). Meanwhile, if the S&P 500 gave back all of its 18% over that same time period, PAPR would only decline by 7.70% (PAPR would simply give back its current return as the S&P 500 went back to the starting price of 2584).
From a risk management perspective, here are some key items to note for PAPR:
- PAPR is trading 7.70% above its starting price ($24.02) from the beginning of the outcome period, this is below the 18% gain seen in the S&P 500 and the 14.61% cap in PAPR. The current return trails the index and its cap because there is still so much time left in the outcome period (time value).
- If the S&P 500 declines 25% between now and March 31, 2021, PAPR will only decline 7.70% (a 25% decline in S&P 500 from the current 3055 level takes it down to 2291 which is above the 2217 buffer level in PAPR). PAPR will give back the 7.70% gain it has, but will not participate in the losses from 2584 to 2291 in the S&P 500 since that would still leave it above the buffer level of 2217.
- If you factor PAPR’s current forward gain (6.90%) into the current price of the S&P 500 that gives you an equivalent S&P 500 level of 3265. This is the level the S&P 500 has to be above at the end of the outcome period for an S&P 500 index fund to outperform the current forward return baked into PAPR.
- If the S&P 500 falls 3% to 2962 from 3055 between now and the end of the outcome period, PAPR will still rise an additional 6.90% from here. PAPR will rise up to its cap the closer it gets to the end of the outcome period, provided the S&P 500 is still at or above 2962.
Getting paid to wait
So the big question is do you believe the S&P 500 will be above 3265 at the end of March 2021? And if so, by how much? If you have high conviction that we’re in the early stages of a move back to the all-time highs (3400) then an investment in PAPR will underperform the S&P 500. In the event the S&P 500 moves back to all-time highs by March 2021, an uncapped index fund will return 11% from here. However, if you’re less confident, then getting paid almost 7% to wait for the S&P 500 to potentially trade in a range is very attractive.
The idea that you can get “paid to wait” stems from the fact that if the market does absolutely nothing between now and March 2021, PAPR will rise to its cap. And that level is nearly 7% higher than the current share price. Furthermore, there’s a scenario where the S&P 500 can trade lower from here, and PAPR will still increase in value. The interactive graph below shows how PAPR will perform from today’s price relative to the S&P 500 between now and the end of the outcome period:
As the graph shows, the S&P 500 could fall 5% between now and March 31, 2021, and PAPR would actually post a positive return of 4.50%. Moreover, the S&P 500 could fall 20% between now and then, and PAPR would only decline by 7.70, a spread of more than 12% in PAPR’s favor! As you can see, this is a more defensive position to take. But it’s one that still offers upside exposure up to 6.90%. And most appealing is you don’t even need the S&P 500 to do anything between now and the end of the outcome period to achieve that 6.90% return.
If the index is flat for the next 10 months, PAPR will float higher as time value decreases. The biggest downside to PAPR is its capped return of 6.90% from current levels (remember, it can’t return more than it’s total return cap of 14.61% and it’s already up 7.70%).
As we’ve discussed in prior articles, success in the market is less about what the market is doing, and more about how you choose to participate. Markets are going to do whatever they’re going to do, you have zero control over them. But you can control your own decision making. Buffered ETFs like PAPR offer strategic ways to potentially lock in a fixed-rate like return. Just make sure you understand the tradeoffs; PAPR will outperform a flat market, a lower market, or a slightly higher one. But it will trail the market in the event of a very strong rally over the next 10 months.
The opportunity highlighted in PAPR is just one of many we evaluate on a month-by-month basis. In fact, there are a number of appealing opportunities in these buffered ETFs if you’re willing to do some homework. Some buffered ETFs have higher return potential than PAPR, and some have lower. Again, it’s all about what trade-offs you’re willing to accept. If you’re a current client, you’ve probably noticed some of these ETF types in your portfolio. If you’re an interested investor, reach out to us to learn how we can leverage buffered ETFs to help you navigate unpredictable markets.
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