Seeking Alpha

Dump The SPY And Buy This ETF Instead

Includes: SPY, UJUL
by: Kurtis Hemmerling

A new suite of ETFs by Innovator might provide a timely solution for current market woes.

These ETFs are created using long-term options.

They track the S&P 500 to the upside (with a cap) and provide a hedge (buffer) on the downside.

The S&P 500 (SPY) just pulled back giving you a discounted buying opportunity. But wait... the market is overvalued and interest rates are climbing... maybe this is just the beginning of a new bear market. Should you buy, hold or sell?

This is the unenviable position many investors find themselves in. If the recent volatility is just a head-fake, you will want to stay invested. If the market is about to drop another 20–30%, you will want to have some protection against those losses. Wouldn't it be great if you could position yourself for positive returns if the market rises yet protect yourself if the market crashes?

If the above scenario describes your concerns and desires, consider the new suite of ETFs by Innovator. After researching these ETFs further, you may want to drop the SPY and pick up these ETFs instead.

Innovator Defined Outcome ETFs

The Innovator Defined Outcome ETFs have the objective of matching S&P 500 performance to the upside while providing a buffer to the downside. They use options to achieve these goals. It is easier if I just show you an example with the Innovator S&P 500 Ultra Buffer ETF (BATS:UJUL) (BATS:UOCT).

The most recent iteration of Innovator S&P 500 Ultra Buffer ETF was available for trading on October 1, 2018. The outcome period was for one year or 365 days. Although you can sell this ETF at any time, to achieve the outcomes discussed in this article, you will need to hold the ETF until the end of the outcome period.

Risk-to-Reward Profile of Innovator S&P 500 Ultra Buffer ETF (UOCT)

UOTC ETF Outcome Period Returns Inception
Let’s start by examining the above diagram which states the risk-to-reward profile if we had invested on October 1.

  • The Outcome Period is 365 days.
  • The Cap, or maximum potential return, is 9.99%. This is true whether the S&P 500 goes up 10% or 10,000% over the next year. After the 10% return, all subsequent upside returns are capped. Of course, selling early would be a viable choice if this occurs in order to free up our capital.
  • Next look at the column header, Downside Before Buffer. This represents the loss an investor will take before the buffer (downside protection) kicks in. If you purchased this ETF on October 1, you are on the hook for the first 5% loss of the S&P 500.
  • Finally, look the Buffer column header. If you had purchased this fund on October 1, you would have 30% buffer protection to the downside. This only kicks in after you eat up the first 5% loss and provided you hold for the full outcome period.

Here is a quick review: you purchased this ETF on the first possible trading day. You have a maximum potential return of roughly 10%. If the market falls anywhere between 5% and 35%, you experience a loss of only 5%. The first 5% loss is on you, the next 30% is hedged. If the market falls more than 35%, your returns will reflect this. If the market rises more than 10%, your returns will be capped at 10%.

But what if you didn’t purchase this ETF on the first day it was available? The risk-to-reward profile for prospective investors will change based on when they invest. The good news is that the Innovator website (I strongly encourage you to read about it here) provides an easy-to-read chart which highlights your new risk-to-reward profile. This is reflected in the chart below.

Risk to Return of Innovator ETFs Consider the current scenario as of when I am writing this article. We will focus on the Current Outcome Period Values portion of the diagram.

Current Outcome Scenario with Ultra Buffer ETF (UOCT)

The S&P 500 (SPY) pulled back just over 5% over the past couple of weeks.

S&P 500 pullback chart

So if the S&P 500 pulls back 5%, then the downside before buffer of the Ultra Buffer ETF is completely gone and my upside potential is 5% greater... right? This is only true if you invested from day 1. Any potential investor needs to examine the current risk-to-reward profile on the Innovator website. Remember that this ETF was created using long-term options. The price of options is influenced in part by anticipated volatility and time remaining until expiration. Thus, if the market pulls back 5%, this doesn’t necessarily mean that the ETF will give you a 5% better entry. The stated objectives are true if you buy at inception and hold until the end of the Outcome Period. If you buy at any other period, you need to look at the current risk-to-reward profile.

October 15 Risk-to-Reward Profile of Ultra Buffer ETF

  • Remaining Days: 353
  • Remaining Cap: 12.25%
  • Downside Before Buffer: -2.74%
  • Remaining Buffer: 27.22%

If you buy now and hold for the next 353 days, your potential return is capped at 12.25%. Based on today’s market valuation, I would say that is a decent return. And you can always sell early if the market makes a sharp bounce up to former highs in the next couple of months. Notice that despite a pullback of 5%, the downside protection doesn’t kick in quite yet if you are a potential investor who has not yet invested. If you bought at inception and are holding the full term, you should be protected from any future loss. But if you are just buying now, you are on the hook for a future potential drop of 2.74% from today's value. Once the buffer kicks in, you are protected for the subsequent 27.22% drop.

In my opinion, now is the time to consider buying these Innovator Defined Outcome ETFs. You should also look at their other 2 offerings which provide a 9% buffer against market losses (BATS:BOCT) and a 15% buffer (BATS:POCT) based on inception values and holding until the end of the outcome period.

Here is an example of today's risk-to-reward profile for the other 2 ETFs:

  • The Innovator S&P 500 Buffer ETF (BOCT) currently has upside potential of 18.46% with a hedge against a subsequent 7.12% loss. This would be suitable if you feel strongly that the market could drop a tiny bit more but that the sell-off is almost finished.
  • The Innovator S&P 500 Power Buffer ETF (POCT) has an upside potential of 12.25% remaining and a downside protective buffer of 12.21%. This is suitable if you feel a correction is in order but not a bear market.

When Not to Buy These ETFs

I am not saying that these ETFs are the perfect fit for all markets. Here are some scenarios when you may not want to buy these Defined Outcome ETFs.

  1. You are an investor with an appetite for risk and you see a large upside to the market. Think early 2009.
  2. You are uninterested in the return potential of the S&P 500 and prefer small caps, REITs or some other segment of the market.
  3. You are a frequent trader. While you can sell these ETFs early, be prepared to hold for the entire outcome period unless you want an unexpected outcome. Buy and hold for the predefined outcome.
  4. You simply do not understand or trust derivatives. If this is true, I would encourage you to study up on options instead of just ignoring them. But be sure to understand your risks going into these products.
  5. You feel that the expense ratio of 0.79% is too high. Personally, I think it is a bargain for what you are getting and considering the complexity of creating these positions with options.

Final Thoughts

Will the market bounce back? Is this the start of a new bear market? I don’t know. Nobody does.

If you are comfortable riding it out and can sleep well at night – fine. But if you are happy with a maximum return of roughly 12% over the next 11–12 months with a strong downside protection of 27%, if markets continue to drop, consider S&P 500 Ultra Buffer ETF (UOCT).

My personal opinion for most mom and pop investors is to replace any S&P 500 ETF holdings (SPY) with one of the Innovator ETFs to limit any potential losses while having a decent upside return potential. As always, do your own homework and make your own decision as I don't know you or your personal circumstances.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.