How a Loss-Proof ETF Can Factor Into Retirement Portfolios

Back in mid-July, Innovator Capital Management grabbed financial media headlines by launching what the firm says is the first-of-its-kind buffer exchange-traded fund designed to protect against 100% of stock market losses.

Innovator Capital Management, which is known for creating and popularizing buffer ETFs, first started marketing such products back in 2018, and it now offers a growing array of buffer funds that the firm says can shield investors against a wide range of losses, should their respective gauges drop.

This week, two experts with the firm offered advisors an hour-long crash course about the latest 100% buffer ETF. The recently launched fund trades under the ticker TJUL and is designed to track S&P 500 returns up to a capped percentage over a two-year period.

As noted by Innovator ETF vice presidents Trey Martin and Tim Urbanowicz, the conditions in the options market upon TJUL’s mid-July launch allowed the first iteration of the two-year defined outcome fund to offer a 16.6% upside cap gross of fees. Net of the fund’s 79 basis point expense ratio, the pair explain, the two-year return cap is about 15%.

According to the duo, all of Innovator’s defined-outcome ETFs are meant to allow investors to take advantage of market growth while maintaining defined levels of buffers against loss. The ETFs are as tax-efficient as traditional ETFs, they note, due to a recent rule change allowing the in-kind trading of options.

While Martin and Urbanowicz say the latest fund has characteristics that can be attractive to a variety of investors, they pointed specifically to its potential use for investors who need to maintain excess liquidity but who also want to avoid “cash drag” in their portfolios.

Among the investor types that fit this description best are near-retirees and retired investors who need to pursue growth to meet their longevity expectations but who are also exposed to the dangers of sequence of returns risk. In such cases, Martin and Urbanowicz suggest, the two-year 100% buffer ETF can make a lot of sense as a replacement for some of a traditional retirement portfolio’s fixed-income allocations.

Getting Cash Off the Sidelines

As Martin and Urbanowicz emphasize, investors today have significantly higher cash holdings relative to previous decades, thanks to a variety of causes. This is particularly true in the high-net-worth client segment.

“The group who we call high-net-worth investors holds about 34% of their net worth in cash, relative to just 22% in equities,” Urbanowicz says. “This cash allocation is up more than 10% over the last decade. I think investors have responded to all the volatility we have seen by moving towards cash, but in doing so they have missed out on substantial additional return potential.”

Martin and Urbanowicz note that U.S. bank deposits have risen to a record level, near $17 trillion. And while interest rates have climbed substantially in the last 18 months, the rates paid out in many savings accounts remain relatively low, meaning many investors’ cash is generating a negative return after accounting for inflation.

According to the duo, there are some obvious and legitimate reasons to ensure that investors at all wealth levels have sufficient liquidity. Having to pull money out of investments to cover both anticipated and emergency expenses is never a great outcome, especially when asset values have fallen. However, it is also clear that excess liquidity comes at a steep cost from a return-seeking perspective.

As Martin and Urbanowicz explain, all else being equal, an additional 5% allocation to cash in the typical retirement investor’s portfolio will spell a 9% lower portfolio value over a three-decade savings journey. A 20% cash allocation will rob a full third of the ending value.

Martin and Urbanowicz say investing in buffer ETFs present a great way for volatility-fearing investors to feel better about getting cash off the sideline, given that they offer downside protection while also allowing investors to participate in much of the market’s potential upside.

To be clear, unlike certain insurance products and structured products, such ETFs are not backed by the faith and credit of an issuing institution like an insurance company or a bank. This also means that Innovator’s buffer ETFs are not exposed to credit risk.

“The options held by the ETFs are guaranteed for settlement by the Options Clearing Corporation,” Martin explains. “In the unlikely event that the OCC becomes insolvent or is otherwise unable to meet its settlement obligations, the ETFs could suffer significant losses. However, regulators have heightened their oversight of the OCC due to its designation as a systemically important financial market utility.”