An ETF Strategy to Smooth Out the Volatility in Small-Cap Exposure | ETF Trends

Small-capitalization stocks have been a good source of returns over the years, but the outperformance has come with its fair share of volatility. Exchange traded fund investors, though, can look to an options-based small-cap strategy to mitigate some of the more extreme market moves.

According to global index provider FTSE Russell, the benchmark small-cap Russell 2000 Index has returned 6.6% annually over the past two decades ended September 30 on a price basis, compared to a 4.6% annual price return for the large-cap Russell 1000 Index over the same period.

While the small-cap benchmark’s returns look relatively attractive over the long term, the outperformance also came with much higher relative volatility. Specifically, the Russell 2000 experienced a 19.5% annualized standard deviation over the last 20 years, compared to 14.8% for the Russell 1000. Additionally, the Russell 2000 saw a maximum drawdown of 54% over the period.

As a way to mitigate the volatility that market indices experience over time, index-based options strategies have grown more popular, especially in recent years marked by heightened volatility. These index-based options strategies can capture the upside potential of the underlying index and better help ensure capital preservation over time.

“Option overlays are an established type of strategy that can provide a means of mitigating against adverse market index movement. For an additional expense they can be added to a market index to offset certain market exposures,” Martin Howard, senior research analyst, FTSE Russell, said in a note.

Index-based options strategies are comprised of a basket of index options to create a downside buffer alongside an upside performance cap, and these strategies can now be accessed through a simple ETF.

Specifically, the Innovator Russell 2000 Power Buffer ETF (KOCT) or so-called Defined Outcome ETF is based on the Russell 2000 Price Index and offers a buffer against the first 15% of losses over their outcome periods. The ETF is held indefinitely and its underlying buffer is reset at the end of each outcome period, approximately annually.

“Innovator ETFs wanted to develop an ETF that matched the one year price return of the Russell 2000 Index with a cap while limiting downside losses. The new ETF based on a Russell 2000 Index-based options strategy allows investors to remain invested in U.S. small-cap stocks with a built-in 15% buffer,” Graham Day, vice president of product & research, Innovator ETFs, said in a note.

For more information on small-cap strategies, visit our small-cap category.