In the rapidly shifting terrain of financial markets, the adaptability of investment strategies can be a decisive factor in their success. This post delves into the potential benefits that flexibility in approach could have on structured investment products, particularly compared to traditional buffered and hedged equity ETFs.
The Limitations of Fixed Rules: Buffered ETFs
Buffered ETFs are tailored to offer investors a specific range of outcomes over a predetermined period, typically one year. These funds maintain a long position in a benchmark index like the S&P 500, using options to cap potential losses and gains. For instance, a buffered ETF might limit losses to -9% and gains to +15%. This is achieved by buying puts to protect against declines and selling calls to offset the cost, which simultaneously caps the upside.
While the predictability of returns in buffered ETFs can be attractive, this rigidity introduces several drawbacks:
- Inflexibility in Market Timing: By locking into options at set levels irrespective of market conditions and pricing, these funds may engage in suboptimal transactions, particularly if put options are overpriced or call options are underpriced.
- Impact of a Set Calendar: The performance of buffered funds can vary greatly depending on the fund’s start date, introducing a large degree of “timing luck” which can affect investor outcomes.
- Path Dependence: Although a buffered fund may protect against a 9% decline at the reset period, if the market experiences significant gains early in the cycle, this can substantially affect the relative protection offered. For instance, if the S&P 500 swiftly moves 10% higher post-reset, the ETF would then need to contend with a potential 19% downturn (more than double the initial protection level). This can create difficulties when placing new clients into an advisor’s model portfolios, since the potential upside experienced early in the period would no longer be available, altering the risk-return profile significantly.
The following chart shows the performance of all Buffered Funds with a five-year history through March 31, 2024, that protect a portfolio against the first 9% of losses that have buffered periods starting and ending January, April, July, and October of each year to show how much dispersion strategies with identical rules, but different buffered windows, have experienced.
Source: Aptus, Morningstar
Shortcomings in Hedged Equity Products
Like buffered strategies, hedged equity products implement a strategy of buying puts and selling calls, but they do so in shorter, often quarterly cycles. The inability to adjust these cycles to market conditions can result in varied performance outcomes based on the arbitrary timing of their resets (e.g., starting in January, then adjusting in April, July, and October versus starting in March, then adjusting in June, September, and December).
These funds can exhibit vastly different performances depending on the reset period and, like buffered strategies, can be negatively impacted by structural issues.
The following chart shows the performance of equity hedged funds from their inception date through March 31, 2024 that are meant to protect a portfolio against losses of between -5% and -20% over three month periods that roll options 1) December, March, June, September, 2) January, April, July, October, or 3) February, May, August, November to show much dispersion strategies with identical rules, but different three months hedging periods, have experienced.
Source: Aptus, Morningstar
The Case for Flexibility
Both buffered ETFs and hedged equity products illustrate how fixed strategies might impede performance. Here’s why a shift toward more flexible, unconstrained approaches could be beneficial:
- Adaptive Option Management: Unconstrained funds are not required to adhere to preset intervals for buying or selling options. This flexibility allows fund managers to capitalize on favorable market conditions, potentially enhancing returns.
- Dynamic Risk Management: By adjusting strategies in real-time, these funds can respond to market volatility more effectively, tailoring their level of exposure and ensuring more consistent protection for investors given current market dynamics and index levels.
- Mitigation of Timing Luck: Flexible funds can initiate or modify their strategies at optimal times, reducing reliance on the luck associated with fixed start and end dates, and ensuring a more consistent return path over time.
Integrating Flexibility for Better Outcomes
We believe the integration of flexibility into the investment framework of hedged equity products can dramatically improve their appeal to both advisors and their clients through improved consistency, reliability, and efficacy. Allowing for real-time adjustments based on market conditions, rather than rigid timetables, these funds could offer enhanced protection, potentially higher returns, and a consistency that buffered funds and hedged equity products have failed to provide.
Investors benefit from strategies that are not only tailored to current market conditions but are also capable of adjusting to unforeseen changes, providing a more robust investment approach.
Conclusion
As financial markets continue to evolve, the demand for investment products that provide more consistent outcomes, less reliance on traditional diversifiers, and the ability to adapt to changing conditions will grow. Incorporating greater flexibility into these products is compelling. Such an approach could lead to more effective risk management, enhanced returns, and better alignment with investor goals, ultimately setting a new standard in the design and execution of financial products.
Embracing unconstrained flexibility might well be the key to navigating the complexities of today’s financial landscapes.
Disclosures
Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward-looking statements cannot be guaranteed.
This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.
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