The most popular defined outcome ETFs cap upside equity exposure and offer downside protection over a set period of time.aprott/iStockPhoto / Getty Images
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Some clients want to have their cake and eat it too. A relatively new type of investment product is trying to offer just that.
Defined outcome exchange-traded funds (ETFs) come in different strategies, but the most popular cap upside equity exposure and offer downside protection over a set period.
“For someone approaching retirement, still wanting equity in their portfolio … these could be a good option,” says Tiffany Zhang, vice-president of ETFs and financial products research at National Bank Financial Inc. – especially amid concerns that markets are overvalued.
Despite their purported utility and being offered in Canada by First Trust Canada (FT Portfolios Canada Co.) since 2019, defined outcome ETFs have not caught on widely with investors, Ms. Zhang says.
That could change after BMO Global Asset Management introduced its structured outcome ETFs last year, says Andres Rincon, head of ETF sales and strategy at TD Securities Inc.
BMO GAM’s large marketing reach is likely to help grow this somewhat sleepy subset of ETFs, he says, which accounts for less than $200-million in assets under management (AUM) in Canada, compared to US$40-billion in AUM in the U.S.
The U.S. market has more than 270 different defined outcome ETFs, although that’s due largely to issuers offering ETFs with different one-year terms on a quarterly basis for the same underlying index, Ms. Zhang says. In addition, the U.S. ETFs cover more than the S&P 500, with defined outcome ETFs for fixed income and commodities.
In Canada, all but one of the 11 ETFs from First Trust and BMO are focused on the S&P 500. The lone outlier is BMO Canadian Banks Accelerator ETF ZEBA-NE, offering double the return of BMO Equal Weight Banks Index ETF ZEB-T if banks exhibit slow growth, but capping the upside in a stronger market.
Mr. Rincon says another reason for defined outcome ETFs’ slow growth in Canada could be the popularity of structured notes, a $40-billion market in Canada with essentially the same strategies.
Defined outcome ETFs “have democratized structured notes,” which generally have high minimum investments, he notes, and made them accessible to more investors.
Advisors may be familiar with structured notes and thus well-positioned to use the defined outcome ETFs, only they aren’t familiar with the products. Sara Petrcich, head of ETF and structured solutions at BMO GAM, says that’s why the firm is spending time educating advisors and investors.
One key point is their ease of use, allowing investors to implement options overlays without the challenges of managing them, Ms. Petrcich says. “As an asset manager, we manage the strategies in products ... for investors.”
Although the ETFs offer defined outcomes, usually for a one-year term, they renew at the end, affording a buy-and-hold strategy, whereas structured notes expire and require reinvestment.
The most popular are buffer ETFs, offering downside protection in exchange for limiting the upside of the underlying asset, Ms. Petrcich says. “These tend to be used as part of a portfolio to give a bit more of a conservative slant.”
Using a put options spread for downside protection and selling call options to fund the cost of that insurance, buffer ETFs give investors equity exposure while reducing, if not eliminating, losses in a down market at the end of a one-year period.
For example, BMO US Equity Buffer Hedged to CAD ETF – April ZEBA-NE provides exposure to the S&P 500, capping gains at 10 per cent while providing protection up to a decline in the index of 15 per cent from the date the fund listed (April 1) to the last business day in March, 2025.
At that point, unitholders’ capital is adjusted to reflect the outcome and the fund resets for the next one-year term.
If the S&P 500 is down 15 per cent at the end of the term, investors who purchased the ETF at its launch would not experience a loss. If the index was down 17 per cent, investors would realize roughly a 2-per-cent loss.
Yet, the upside is capped, so if the S&P gained 20 per cent at the end of that term, unitholders would only realize an increase of about 10 per cent.
BMO GAM offers three other versions of this strategy issued in October, January and July.
First Trust offers a similar suite, along with an ETF of ETFs, First Trust Vest Fund of Buffer ETFs BUFR-NE, that provides laddered exposure to its four quarterly buffer ETFs.
As the BMO GAM ETFs’ terms progress toward expiry, their unit value rises and falls with the values of their options strategies, Ms. Petrcich says. Unit values may rise if the market outlook is bearish, or fall on bullish sentiment.
“The continuous availability of products, struck at more current market prices” gives investors more choice to pick an ETF that best reflects their outlook on the underlying market index, she adds.
The strategy is not without additional cost.
Management fees – an estimated 0.73 per cent management expense ratio (MER) for the BMO buffer ETFs and around 0.91 per cent for the First Trust products – are much higher than the 0.10 per cent MER for a typical ETF tracking the S&P 500.
Given that extra expense, portfolio manager Alan Fustey with Adaptive ETF at Bellwether Investment Inc. in Winnipeg is skeptical.
“These are marketed as having your cake and eating it too, but you can probably get the same risk trade-off with simple asset allocation and save on fees,” he says.
If downside risk is the concern for clients, it’s better to reduce exposure to equities and increase exposure to cash and fixed income for similar risk-adjusted returns at lower cost, he notes.
For example, an advisor could invest 20 per cent in an S&P 500 ETF with the remaining capital in a Treasury bill. “One year down the road, the odds are pretty good you get the same outcome,” he says.
Still, Ms. Petrcich says more investors – particularly retirees – are likely to see the utility in defined outcome ETFs as the U.S. equity market continues to appear overvalued and the U.S. Federal Reserve Board remains focused on bringing inflation under control.
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