As we consider the potential hurdles in the new year, investors can focus on alternative ETF strategies to potentially generate positive returns in flat or down-market conditions through a built-in downside risk mitigation methodology.
In the recent webcast, Managing New Challenges in 2023, Tim Urbanowicz, head of Research & Investment Strategy at Innovator ETFs, noted that we are now dealing with a lower-no-longer environment as the Federal Reserve has maintained its aggressive monetary policy tightening to combat stubbornly high inflationary pressures that continue to persist. While inflation has somewhat slowed, the Fed could maintain its tightening course through the year to get ahead of the curve.
Meanwhile, the fixed income markets can no longer count on the Fed to support bond markets after policymakers ended quantitative easing. The Fed is now a majority holder of government bonds, accounting for about 22% of U.S. debt, compared to just making up 7.1% back in pre-QE September 2008.
With lingering uncertainties, Grant Copple, external sales consultant at Innovator ETFs, highlighted alternative portfolio solutions that could help limit risk exposure. For example, the Innovator Premium Income 40 Barrier ETF (APRQ) offers high-income potential with a 40% barrier to help hedge low/negative returns.
Additionally, investors can turn to something like the Innovator Defined Wealth Shield ETF (BALT) to help defend against further downturns. BALT uses options on SPY (SPDR S&P 500 ETF Trust) in seeking to provide exposure to the equity market to a cap while targeting a significant buffer against losses in SPY each calendar quarter.
BALT targets a 20% buffer every three-month outcome period. The ETF can be held indefinitely, resetting at the end of each outcome period. While the ETF targets a 20% buffer, it could range from 15% to 20%. BALT includes synthetic 1:1 exposure to the S&P 500 ETF (SPY), a put spread to provide a buffer targeting 20% and sell on the upside call to finance downside buffers. The strategy can help hedge interest rates and credit risk.
Urbanowicz also warned that we are waiting for the other shoe to drop. For instance, unemployment rates deteriorate on a delay after a tightening cycle begins. Since the 1970s, it took an average of nine months after a rate hike cycle starts before consumer spending began falling. Additionally, it took an average of 35 months after a rate hike cycle started before consumer spending bottomed. Since the 1950s, it took an average of 6.8 months after the last interest rate hike before the start of a recession.
To help hedge against any potential recession risks or downturns ahead, Copple pointed to defensive strategies like the Innovator Equity Managed Floor ETF (NYSE Arca: SFLR) and the Innovator S&P 500 Power Buffer ETF (PJAN).
SFLR can help deliver U.S. equity upside and income while limiting a shareholder’s potential for maximum loss through a sophisticated options overlay. The ETF’s portfolio consists predominantly of S&P 500 Index stocks, with the sub-advisor implementing a representative sampling strategy to efficiently gain exposure to returns of the referenced index. As part of the equity sampling methodology, SFLR will seek to provide investment income, distributing dividends from the portfolio’s stock holdings back to fund shareholders.
Through a custom-developed, laddered options strategy, SFLR will target a maximum loss of roughly 10% on a rolling 12-month basis. The laddered options strategy employed by SFLR seeks to maximize upside potential. This should allow investors to participate in high-returning environments more fully for the fund’s large-cap domestic stock benchmark.
PJAN is part of Innovator’s Defined Outcome ETF suite with a built-in buffer to help investors hedge against risks ahead, depending on one’s level of risk aversion. The ETFs start with a synthetic one-to-one exposure to the target market. They would then include a put spread to provide targeted buffers of 9%, 15%, or 30% to their respective targets. Lastly, the upside is capped by selling an upside call to finance downside buffers.
“Innovator’s Buffer ETFs were designed to provide investors a greater degree certainty around their investment outcomes,” Copple said.
In addition, Urbanowicz cautioned of a potential earnings recession with rangebound valuations ahead as growth slows down.
In this type of weakening economic environment with a greater likelihood of lower portfolio returns, Copple argued that investors could turn to ETF solutions like the Innovator U.S. Equity Accelerated 9 Buffer ETF (XBJA), the Innovator Premium Income 20 Barrier ETF (APRH) and the Innovator MSCI EAFE Power Buffer ETF (IJAN) to enhance a portfolio’s capabilities.
Investors should expect accelerated ETFs to hit performance cap finishes below the reference asset during strong up markets, or they can hit performance caps above the reference asset in normal up-market conditions. During down-market conditions, the strategy matches the performance of the reference asset. The result is a way to combat low returns.
The Premium Income Barrier strategy also targets high-income potential and hedges against low or negative returns.
Lastly, IJAN will provide the price return of the underlying benchmark MSCI EAFE Index with up to a predetermined cap, while buffering investors against the first 15% of losses over the outcome period. The ETF can be held indefinitely, resetting at the end of each outcome period, approximately annually. The ETF offers a hedged equity exposure.
Financial advisors who are interested in learning more about a risk-managed investment approach can watch the webcast here on demand.