Funds with targeted outcomes over specific periods bring some degree of certainty to the inherent risks of investing in the financial markets.
In Canada, the pioneer of this genre of equity ETFs is the First Trust Cboe Vest U.S. Equity Buffer suite offered by Toronto-based FT Portfolios Canada Co., which operates as First Trust Canada. Launched in August 2019, and holding a combination of call and put options, these ETFs provide partial protection against downturns in the U.S. stock market as represented by the S&P 500 price index. Returns are in the form of capital gains.
The RBC Target series, managed by Toronto-based RBC Global Asset Management Inc., offers outcome-related investing on the fixed-income side. Unlike conventional bond ETFs, the RBC buy-and-hold corporate portfolios gradually decline in duration until they reach their maturity dates and terminate. Launched in September 2011, the series constituted RBC’s first ETFs.
Though the First Trust and RBC offerings are in different asset classes, the common theme is risk management tied to specific holding periods.
Provided investors hold them until maturity, the total return of the RBC Target ETFs will be as predictable as it would be if the underlying bonds were held directly. Moreover, the ETFs enable retail investors to hold a diversified portfolio of investment-grade corporate bonds, and to invest modest amounts.
For the First Trust ETFs, options strategies create a so-called buffer that protects investors against the first 10 percentage points of any drop in the S&P 500 index during a specific 12-month period.
Target outcome is a concept that has been around for decades in structured notes and in the insurance world, says Karl Cheong, head of ETFs at First Trust Canada.
“This is nothing new. The innovation has really been the package — that we’re offering it in an ETF,” Cheong says. “A lower-cost, more liquid structure with better tax treatment is a great outcome for the end investor.”
First Trust Canada is an affiliate of Wheaton, Ill.-based First Trust Advisors L.P., which manages the target ETFs while drawing on the expertise of options specialist Cboe Vest Financial LLC, an offshoot of the Chicago Board Options Exchange. The Canadian-listed target outcome ETFs have a combined total of about $40 million in assets, and First Trust Canada’s U.S. affiliates manage about US$1 billion in these types of mandates.
The tradeoff for the 10% buffer is a cap on returns over a 12-month period. According to the prospectus, the caps are expected to range between 8% and 14% before fees and expenses. For the four ETFs in the suite, the actual range was as low as 8.57% for the November version (which had a shortened offering period) and as high as 15.75% for the May version.
The ETFs can be held indefinitely, or bought or sold at any time, but their returns cap is revised every 12 months. The 10% protective buffer stays the same, but the cap on returns will vary depending on the price of S&P options on the rebalancing date. At the time of rebalancing, the biggest factor in determining the cap is market volatility, though interest rates also play a role. In the latest rebalancing on Aug. 21, for the original ETF that trades under the ticker AUGB.F, the cap on returns has been set at 14.71%.
“What we’ve communicated to advisors and to their investors is that this is a low-volatility structured outcome,” says Cheong. “That’s been the pattern of the returns so far, and you have a targeted outcome in the future that doesn’t rely on any historical correlations.”
Cheong estimates that the beta of the First Trust ETFs, relative to the S&P 500, is 0.5 to 0.6. (By definition, the beta of the index itself is 1.0.) Because of this attribute, the ETFs represent an alternative to U.S. equity ETFs that employ low-volatility methodologies.
But since most low-volatility ETFs are based on stock selection, their resilience isn’t a sure thing.
“Many advisors and investors have relied on low volatility for downside protection. But it didn’t actually deliver when there’s a risk-off market and the correlations went to one for everything,” says Cheong, referring to the market plunge in March in response to the coronavirus pandemic.
By contrast, First Trust’s 10% buffer is “hard coded” into the options strategy and isn’t dependent on market conditions. “In any down scenario with the S&P 500 we’ll beat the market,” says Cheong. “That’s what it’s designed to do.”
This protection comes at a cost. The management expense ratio (MER) of 0.93% for the First Trust ETFs is much higher than the MER of 10 basis points or less for passive index ETFs that track the S&P 500, and which pay dividends.
In between rebalancing for the First Trust ETFs, there can be trading opportunities but also pitfalls. As noted in the prospectus, if the investor buys the ETF after the net asset value has already fallen below the 10% buffer, there will be no protection against further losses.
Conversely, if the ETF is bought after the units have already exceeded their original price as of the rebalancing date, losses may be experienced before the protection provided by the buffer kicks in. An interactive tool on the First Trust website is designed to help investors evaluate entry and exit points.
With the RBC Target ETFs, there’s initially no significant difference in risk at the time of issue when compared to high-quality corporate bond ETFs with the same duration. But that’s where the similarity ends.
“These ETFs act more like individual bonds and mature over time,” says Jonathan Hartman, head of advisor channel sales at RBC GAM.
There’s reinvestment risk at maturity, Hartman acknowledges, but no different than that of a conventional bond ETF whose manager must decide whether to hold or trade. “The risk is the same. It’s just a matter of whether it’s being managed by a portfolio manager or being managed by the advisor or the end client.”
There are six RBC Target fixed-income ETFs, with combined assets of more than $460 million and maturity dates one year apart from 2020 to 2025. That’s down from eight ETFs when the suite launched nine years ago, since RBC GAM has determined there is insufficient demand for the longest-dated ones.
If a liability is coming due or the client needs to make a purchase at a specific time in the future, a target-maturity ETF can be chosen to match that period. As a group, the ETFs can serve as tools for building a laddered fixed-income portfolio with maturities ranging from one to five years.
Hartman says there are also potential applications for investors who have a specific market view or a portfolio component that they feel is missing: “That investor can pick a specific point on the yield curve to fill in a gap or to overweight a specific time period, based on that view.”
RBC GAM also offers laddered portfolio ETFs, two of which invest wholly or partly in the target maturity ETFs. They include the $134-million RBC 1-5 Year Laddered Corporate Bond ETF. It holds equal weights in five of the target-maturity ETFs. There is no additional management fee beyond those of the component ETFs, most of which have MERs of 0.28%.
“We’ve been able to build out a platform of strategies where we can manage and do things for you, or we can provide you with the component parts if you choose to do that yourself,” says Hartman. “It’s not a one size fits all. These are tools that enable lots of different approaches.”