Exploring Defined Outcome ETFs

This research note was a joint effort of IDX Insights & FactorResearch.

SUMMARY

  • Defined outcome ETFs have quickly gathered almost $5 billion in assets
  • Not unexpected given their much lower drawdowns when the market crashed in March 2020
  • However, they are complex and expensive products and there are viable alternatives

INTRODUCTION

If ETFs had an arch enemy, then it probably would not be mutual funds, but rather structured products. ETFs symbolize simplicity, transparency, liquidity, and low fees. In stark contrast, structured products are generally complex, opaque, difficult to trade, and expensive.

A classic structured product is a note that allows investors to participate in the stock market with defined downside but limited upside (therefore earning the “defined outcome” moniker). The same payoff profile could be constructed via a zero-coupon bond and an option. Retail investors, in particular, like these strategies as they seem to provide attractive risk-reward scenarios with so-called “defined outcomes”. Banks and brokerages like selling these products to retail investors as the fees are lucrative. On the face of it, structured products are not always expensive, some are even free, but the cost disclosure typically does not include the fees from the trading desk that creates and manages these over time.

There has been very little discussion in the media about structured products in comparison to stocks, mutual funds, or ETFs, but structured products represent a huge market with approximately $7 trillion invested globally (which is actually slightly more than the global ETF market). Given that there are more than 7,000 ETFs covering almost every imaginable index, sector, or theme, issuers have (not surprisingly) turned to importing ideas from the structured product market to the ETF world.