Downside-protected ETFs probably aren’t worth your time, unless you’re short on time

INVESTORS have differing risk tolerances, but a common goal would perhaps be to make the maximum amount of returns for the lowest amount of risk.

To do so, they may be enticed by new products, such as downside-protected exchange-traded funds (ETFs).

Such defined-outcome ETFs try to provide investors the best of both worlds: investing in strong equity markets, such as the S&P 500 in the United States, while limiting the losses that they make along the way.

A downside-protected ETF is created by buying a mix of put and call options. Options are contracts that give the right to buy or sell a security at a specified price, or “strike price” by a chosen expiration date.

For a downside-protected S&P 500 ETF, for example, ETF providers typically buy a deep-in-the-money call option on the S&P 500. Such a call option has a strike price that is much lower than the index’s current performance. As a result, the call option’s price tracks the index closely.

Next, providers buy a put option, or an option to sell the S&P 500 at a maximum loss level.

Last, they sell a call option, or an option to buy the S&P 500 at a higher price that forms a cap on the potential upside on the ETF. This pays for the earlier put option that was bought to create a floor at the maximum loss level.

While this seems awfully complicated, all this is to say that such an ETF will promise to limit your downside, but also have upside caps that could be lower than how the S&P 500 performs eventually.

There could be some value to investing in such a product.

In the previous edition of Making Bank, I made it a point to compare the maximum drawdown of different indices because a certain cohort of investors, such as those who have near-term cash needs, cannot afford steep drawdowns.

Such investors may have common expenses such as downpayments for a house or wedding expenses in a year’s time.

For these investors, a downside-protected ETF may be a way for them to achieve higher returns than they otherwise could, especially as interest rates begin to fall.

Already, the Singapore six-month Treasury bill’s cut-off yield has fallen from a high of 4.4 per cent in December 2022 to 3.06 per cent in the latest auction on Oct 10.

However, for everyone else, there are costs to using such products.

In a report released in July this year, Morningstar research analyst Lan Anh Tran noted in a table of four ETF providers that such ETFs come with annual fees of between 0.5 per cent and 0.85 per cent. In comparison, the iShares Core S&P 500 ETF charges a management fee of just 0.03 per cent.

The opportunity cost of using such products is also significant since the S&P 500 yielded positive returns 80 per cent of the time on a 12-month rolling basis.

Tran said: “Investors with a longer investing horizon and little need for immediate liquidity will be much better off parking their money in the stock market and simply waiting it out.”

Investors could also allocate some funds to bonds, she added. This can also help ease volatility, or that “sinking feeling in your stomach” when the market falls.

Meanwhile, she noted that a downside-protected ETF had a cap of around 10 per cent for the outcome period of July 2024 and July 2025.

“As interest rates come down, however, the cap will also decrease and might lose its appeal,” she pointed out. “While the potential returns might be higher than a certificate of deposit or plain Treasury bills, investors can miss out on substantial stock-market gains.”

Another way to gain exposure to such downside-protected ETFs is with portfolios managed by companies such as investment platform Syfe.

Syfe’s head of investment advisory Ritesh Ganeriwal said that unlike when investors purchase downside-protected ETFs themselves, the platform will re-optimise investors’ ETF holdings semi-annually, subject to investor consent. This means that investors with the company’s portfolio will have their estimated maximum loss level and current upside cap revised.

And unlike current insurance products that provide similar downside protection qualities, such portfolios are liquid.

“They (insurance products) lock up your money and if you redeem early, there are redemption fees and... you don’t really know what you are investing into,” he explained, adding that such ETFs can give people more transparent access to such options strategies.

Even so, Ganeriwal does not recommend that investors purchase the downside-protected S&P 500 portfolio to replace their stock exposure.

Instead, he suggested that a moderate-risk investor, who has a typical portfolio with 60 per cent of their funds put in stocks and 40 per cent in bonds, could instead invest about half of the bond exposure into such a diversified portfolio instead.

As at Jun 30, the downside-protected portfolio would have yielded 5 per cent in three-year annualised returns, compared with the 9.5 per cent returns of the S&P 500 index.

As Ganeriwal put it, there is “no free lunch”. He noted: “If you’re protecting your downside, you are giving up some of the upside.”

Personally, I don’t think young investors such as myself should be too worried about downside protection. We have time on our hands, and markets have recovered time and again after significant drawdowns.

Investors, who have major expenses within a year, could temporarily park their money in a money market fund, instead of choosing downside-protected products that may be more expensive and complicated.

Such funds will yield lower returns, but it should not matter that much over such a short span of time.