By Vinit Srivastava, CEO, MerQube.

Vinit Srivastava, CEO, MerQube.

My company’s role creating the fintech that is enabling the next generation of index-linked investing means we speak daily to the world’s major providers of ETFs about what they are working on to address investor requirements.  And, whilst we work with a wide range of clients to help them to create a broad range of approaches, it is very clear that everyone is talking about one set of products and strategies: Defined Outcome ETFs.

First launched in 2018, there are now $9 billion of AUM in these ETFs, largely based in the USA.  This is a relatively small amount, but no one would bet against their growth at the moment.  Because we are hearing that Defined Outcome ETFs are increasingly viewed as sharing the attractive qualities of the $7 trillion structured product market but with all the usual ETF advantages that address some of the challenges associated with these long-standing structured products.  In brief, typically Defined Outcome ETFs provide broader access than Structured Products because they offer lower fees, far greater ease of liquidity, and tradability and they don’t carry an issuing investment bank’s credit risk.

But, primarily, the reason our clients are looking carefully at Defined Outcome ETFs and related strategies is because they provide protection.  For those looking for an ETF strategy that protects value, these new approaches are formulaic and offer mathematical predictability.  That allows more conservative investors to address a market where equity expectations of returns are projected to be lower and there is uncertainty around fixed income given low absolute rate levels and inflation expectations.

Essentially, Defined Outcome ETFs use underlying option-based strategies that allow them to do what they say on the tin – you know what you are going to get when the options expire.  If you are looking at creating a Defined Outcome ETF strategy you can decide (broadly) what benchmark you are tracking and you know your upside potential and downside potential (through a buffer or floor) and you know what the outcome period is for that investment.  There are very few strategies (ETF or otherwise) that provide the prospect of eliminating market uncertainty like this.

Whilst delivering this takes some relatively sophisticated option approaches, the end-product for investors is the simplicity and relatively low costs of ETFs coupled with the confidence provided by option-based strategies.

So how does it work?  Well as ever, there are no free lunches, so for example, to achieve protection from a downturn you are, in effect, selling the potential for significant market upside to protect you from the potential for significant market downside.  It should also be noted that there is nothing particularly new here.  This is simply the democratisation of option strategies with approaches that have been in the market for a very long time being applied to ETFs.

As an example, the graph and table below (please scroll down) showcase how the cap of a buffer for a Defined Outcome ETF product creating an 80% level of protection is calculated: A strike of a call option finances the cost of protection (generated by the put option).

Where will this go next?  Well, it’s fair to say that the industry is looking hard at the Structured Product pay-offs that can be replicated by Defined Outcome ETFs and we are likely to see a proliferation of available products as a result.  The current product set has been focusing on protection and there is room for products geared towards growth or income. These are likely to include features like barrier options and autocallability and products that run for much longer time periods than the current year-long time horizons – making them viable for pensions and institutional players. We will also almost certainly see significant diversification in the underlyings away from the more mainstream benchmarks used now.  That means thematic Defined Outcome ETFs that track the energy or financial sector or even more thematic plays like the ARKK’s innovation ETF or, once we have a liquid listed option market, crypto currencies.

Also, whilst Europe has yet to formally adopt these products it would seem likely that Defined Outcome ETFs will come to this market soon.   The region has, after all, been an innovative leader in a huge variety of options and derivative-based instruments that have been successfully invested in and regulated for decades.

In short, the variety and range of ETF products that are potentially enhanced by option strategies is about to become significantly larger.  And, because these are, essentially ETF products, that is likely to mean that investors, and particularly retail investors, will have access, at low cost, to a much wider range of passive investment strategies than they do at present.  These are early days but given the impact of ETFs on every area of the global financial services industry that they have touched to date, it would seem wise to take note of the rising demand for a new group of products that could represent the next chapter for ETFs.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)