A 100% Buffer: Too Good to be True?

Ask 100 different people about their opinion on a 100% buffer strategy and you’re likely to get 100 different answers. Some will give praise while others will be more critical. In nearly all instances, the answers will be a function of each individual’s starting point and underlying premises. With that in mind, what are some of the key considerations in assessing a 100% buffer strategy and how ought investors think about it?

Are you Better Off Just Owning Equities?

“When you own a broad index of equities, the upside compounds over the long run while drawdowns are temporary. Giving up permanent gains seems like an awful exchange”.

Let’s get this out of the way up front…if you are an investor with a multi-decade time horizon, no liquidity needs along the way, and an appetite for risk, you could grab a cheap broad market index and call it a day. Why own a bond, alternative, buffered strategy, or pay an advisor for that matter? But I believe statements like those above, rooted in academic theory, miss the reality clients live in. Not everyone has a long-time horizon to invest. Liquidity needs come up. Goals need funding. Life happens. Short term volatility and drawdowns can not only be tough to stomach, they can also derail goals and add unnecessary stress.

Take for example an individual nearing retirement. A 20% drawdown could be the difference of hanging it up on the beach in Naples, or working for another 2-3 years. Well, that’s where planning comes in, right? That’s why we hold cash and short-term bonds - to make sure goals will be hit. Right. And that is exactly where a 100% buffered equity strategy may help. To be able to position a portfolio defensively, while still tapping into the compounding power of the equity market mentioned above.

Cash May be Trash…But Investors Still Hold Way too Much of It

“If investors are seeking to avoid market risk altogether, I would question whether they should be participating in stocks in any format — let alone a strategy with relatively high fees and offering no dividend payments”

Cash creates a drag on portfolio returns over time. My colleague, @TomOshea, wrote a great blog on this topic last week, that you can read here: When Cash Isn’t King. The chart below is pulled from his research, and shows the drag a 5%, 10%, and 20% cash allocation creates on a portfolio. A 5% cash allocation results in a 9% lower ending portfolio value. A 10% cash allocation, 17% lower, and a 20% allocation, 32% lower. Said another way, a $1 million initial investment in 1991 with a 20% allocation to cash, would leave an investor with about $7 million less today than the fully allocated equity portfolio.

So just hold the market portfolio, right? Maybe so, but in reality, it’s not what investors do…especially not high net worth investors. In fact, according to the most recent World Wealth Report from Capgemini, high net worth individuals keep an average of 34% of their assets in cash.

Given the drag figures noted above, a 34% cash allocation seems less than ideal. But these are already wealthy individuals. They don’t want to have to make their money twice. This is where a 100% buffer strategy may add value; every advisor out there knows the power of investing in the equity market over time, but reducing the amount of cash clients hold on the sidelines isn’t easy.

Will the 100% buffer strategy wipe out the cash drag completely? No, but its current upside return potential is meaningfully higher than the return potential from a savings or money market account.

Is it Just an Expensive T-Bill?

"I don't expect this ETF to be in high demand. It's effectively a slightly riskier version of T-bills, with a much higher cost."

Stating the obvious first, a 100% buffer strategy currently offers significantly more upside potential than a U.S. Treasury of comparable duration. Can markets go down over periods greater than one year? Yes, so unlike a treasury, there is the chance the strategy does not deliver a positive return. However, looking at 2-year rolling returns on the S&P 500 Index going back to 1950, we see that the index finishes positive in 89% of observations.

Less obvious than the higher return potential, however, is the potential tax advantage. Investors in income-bearing instruments such as savings accounts, CDs, treasuries, or corporate bonds, pay ordinary income rates. For high-net-worth individuals, that equates to a rate of ~40%. With the 100% downside buffer ETF, there is no income, and depending on the holding period, gains can be subject to the long-term capital gains rate, of 20%. The table below offers a simple illustration of how big a difference this can make.

Investors purchasing shares after an outcome period has begun may experience very different results than fund's investment objective. Initial outcome periods are approximately 2-years beginning on the fund's inception date. Following the initial outcome period, each subsequent outcome period will begin on the first day of the month the fund was incepted. After the conclusion of an outcome period, another will begin.

The Bottom Line

Again, as with anything new, there are always early adopters, skeptics and critics. For the 100% buffer strategy, a simple understanding of what it was designed to solve for, how options pricing works, and where it fits in a portfolio, in my opinion, opens up a potentially powerful asset allocation tool.

Defined Outcome ETFs are not backed by the faith and credit of an issuing institution, so they are not exposed to credit risk. ETFs use creation units, which allow for the purchase and sale of assets in the fund collectively. Consequently, ETFs usually generate fewer capital gain distributions overall, which can make them somewhat more tax-efficient than mutual funds.

There is no guarantee the Fund will be successful in providing the sought-after protection.

The Fund has characteristics unlike many other traditional investment products and may not be suitable for all investors. For more information regarding whether an investment in the Fund is right for you, please see "Investor Suitability" in the prospectus.

The outcomes that the Fund seeks to provide may only be realized if you are holding shares on the first day of the Outcome Period and continue to hold them on the last day of the Outcome Period, approximately two years. There is no guarantee that the Outcomes for an Outcome Period will be realized or that the Fund will achieve its investment objective.

The Funds have characteristics unlike many other traditional investment products and may not be suitable for all investors. For more information regarding whether an investment in the Fund is right for you, please see "Investor Suitability" in the prospectus.

Investing involves risks. Loss of principal is possible.?The Funds face numerous market trading risks, including active markets risk, authorized participation concentration risk, buffered loss risk, cap change risk, capped upside return risk, correlation risk, liquidity risk, management risk, market maker risk, market risk, non-diversification risk, operation risk, options risk, trading issues risk, upside participation risk and valuation risk. For a detailed list of fund risks see the prospectus.

There is no guarantee the Fund will be successful in providing the sought-after protection. If the Outcome Period has begun and the Underlying ETF has increased in value, any appreciation of the Fund by virtue of increases in the Underlying ETF since the commencement of the Outcome Period will not be protected by the Buffer, and an investor could experience losses until the Underlying ETF returns to the original price at the commencement of the Outcome Period.

Fund shareholders are subject to an upside return cap (the "Cap") that represents the maximum percentage return an investor can achieve from an investment in the funds' for the Outcome Period, before fees and expenses. If the Outcome Period has begun and the Fund has increased in value to a level near to the Cap, an investor purchasing at that price has little or no ability to achieve gains but remains vulnerable to downside risks. Additionally, the Cap may rise or fall from one Outcome Period to the next. The Cap, and the Fund's position relative to it, should be considered before investing in the Fund. The Fund's website, www.innovatoretfs.com, provides important Fund information as well information relating to the potential outcomes of an investment in a Fund on a daily basis.

These Funds are designed to provide point-to-point exposure to the price return of the Reference Asset via a basket of Flex Options. As a result, the ETFs are not expected to move directly in line with the Reference Asset during the interim period.

FLEX Options Risk?The Fund will utilize FLEX Options issued and guaranteed for settlement by the Options Clearing Corporation (OCC). In the unlikely event that the OCC becomes insolvent or is otherwise unable to meet its settlement obligations, the Fund could suffer significant losses. Additionally, FLEX Options may be less liquid than standard options. In a less liquid market for the FLEX Options, the Fund may have difficulty closing out certain FLEX Options positions at desired times and prices. The values of FLEX Options do not increase or decrease at the same rate as the reference asset and may vary due to factors other than the price of reference asset.

Investing involves risk. Principal loss is possible. All rights reserved. Innovator ETFs are distributed by Foreside Fund Services, LLC.

The Funds' investment objectives, risks, charges and expenses should be considered carefully before investing. The prospectus contains this and other important information, and it may be obtained at innovatoretfs.com. Read it carefully before investing.

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