Structured-outcome ETFs, like market-linked GICs, are designed to appeal to investors who would like stock-market exposure but also want something less risky.
The ETFs and GICs both impose caps on returns, but that’s where the similarities end. While the GICs return at least the principal at maturity, the ETFs have no such guarantee.
On the plus side, the ETFs offer the potential for higher returns and enjoy trading liquidity and tax advantages over GICs, which must be held to maturity and whose returns are fully taxable interest income.
BMO Global Asset Management launched three structured-outcome products in October, joining Toronto-based FT Portfolios Canada Co. — which launched its first target-outcome ETF in August 2019 — as the only other Canadian provider in this niche. First Trust manages a suite of five “buffer” ETFs with a combined total of about $110 million in assets.
Because they use options contracts, target-outcome ETFs charge higher management fees than the 0.1% or less that’s typical of broad-market index ETFs. BMO’s management fees for its new ETFs are 0.65%, while First Trust’s buffer ETFs charge 0.85%.
The four First Trust ETFs with at least three years of history are derived from the price return of the S&P 500 index (CAD-hedged). Each ETF has a target-outcome period that’s reset every 12 months.
If the First Trust ETFs are bought on the day the target outcome is set, and held for the entire 12-month period, they will be protected against the first 10% of any losses.
The capped return differs for each First Trust ETF, and ranged from 17.65% to 23.77% for the outcome period that ended Nov. 17.
The newest ETF in the suite, the First Trust Cboe Vest Fund of Buffer ETFs (Canada) ETF (NEO: BUFR), holds an equally weighted portfolio of the four older ETFs and does not have a buffer or capped return of its own.
The closest competitor to First Trust’s ETFs is the BMO US Equity Buffer Hedged to CAD ETF – October (NEO: ZOCT), whose target-outcome period will end on Sept. 30, 2024. BMO’s buffer of 15% offers more downside protection than First Trust for holding dates that match the 12-month outcome period.
BMO’s return for this period is capped at a less generous 10.5% for the price return of the BMO S&P 500 Hedged to CAD Index ETF (NEO: ZUE). However, the buffer ETF also will pay dividends, which aren’t subject to the cap.
BMO’s returns will be a combination of capital appreciation and dividend income; First Trust pays no dividends. While BMO holds units of its currency-hedged U.S. index ETF, First Trust invests only in SPDR S&P 500 ETF Trust options. Those options contracts are based on the market price, not total returns.
BMO’s other two structured-outcome ETFs — the BMO US Equity Accelerator Hedged to CAD ETF (NEO: ZUEA) and the BMO Canadian Banks Accelerator ETF (NEO: ZEBA) — don’t protect against market losses.
What they do provide, up to specified caps, is double the return of the stock-price indexes over three-month periods. The initial quarterly cap is 7% for the U.S. Equity Accelerator and 6.6% for the Canadian banks ETF.
Here’s an example of how the U.S. cap works. Assuming the market index rose by 3.5% during the quarterly period, the ETF would reach the 7% price cap. In addition, dividends would be payable, which BMO estimates would add another 55 basis points in quarterly returns.
If the market price was flat, the BMO ETF’s return for the three-month period would consist solely of dividend income. And in the event of a price drop over the period, the downside isn’t amplified: investors would experience the same loss as the market while still collecting dividends.
The Accelerator ETFs reset their return caps every three months at levels determined by BMO. As a result, investors and their advisors must frequently reassess the risk/return tradeoff.
Entry and exit points are other key decisions when investing in target-outcome ETFs. For holding periods that don’t match the start and end dates of an outcome period, the level of protection will vary.
If the ETF is bought when the reference stock index is already near its cap, there will be little ability to experience capital gains. Conversely, buying a buffered ETF at a depressed price will leave more scope for gains but less protection from losses, as the downside buffer will be closer.
Target-outcome ETFs face significant competition from market-linked GICs, which are backed by the Canada Deposit Insurance Corp. Furthermore, some GICs provide minimum positive returns over fixed holding periods.
The returns of the RBC U.S. MarketSmart GIC, for example, are based on the percentage increase in the S&P 500 index. Although the index is U.S. dollar-based, payouts to RBC GIC holders are in Canadian dollars.
As of Nov. 19, RBC was quoting a minimum return payable at maturity of 7.6% over a three-year term, and a minimum 12.1% for a five-year term. Expressed in compound annual returns, those figures are 2.5% over three years and 2.3% over five years.
As for the upside, the returns payable at maturity for these same RBC GICs were capped at 25% and 35%, respectively. Compounded annually, that works out to 7.7% over three years and 6.2% over five years.
Potential returns in this range look good next to the actual investment performance of the four First Trust ETFs with multi-year track records. As of Oct. 31, their compound annual three-year returns ranged from 4% to 7.1%.
As would be expected, market-linked GICs and target-outcome ETFs tend to lag pure equities exposure over time. As of Oct. 31, the three-year annual return of ZUE was 8.96%, handily beating the actual returns of the First Trust ETFs and well above the capped maximum returns being quoted for the RBC GICs.