Ask Your Advisor These Questions Before Investing in Defined-Outcome ETFs

Key Takeaways

• You’re going to get a certain amount of upside of the stock market with a very limited amount of downside.
• The most popular outcome period for these funds is once a year, but it can vary widely. It’s really important that investors read the fine print on these because of that time frame.
• There’s a handful of mutual fund versions of defined-outcome funds, but predominantly it’s ETFs. The average expense ratio is about 80 basis points.
• Defined-outcome ETFs are not new, but we’re definitely seeing a lot more of them being launched and a lot more interest in them. The growing amount of launches is partly because of the way they’re structured. Usually they have a one-year period, so an asset manager will launch one that starts and ends every month.
• More than half of defined-outcome funds have been launched since 2023, so we really haven’t seen a shock period for the majority of them.
• The advantages of these vehicles are that you are getting what you pay for if you use them correctly. The cons are that they could be hard to use correctly. You really do have to line up your time horizon with the way the time horizon is built in the product.
• These funds are good for conservative investors. They can act like a fixed-income alternative in an investing portfolio.

Susan Dziubinski: I’m Susan Dziubinski with Morningstar. Advisors who are trying to give their clients some peace of mind after a long-running rally in US stocks may be introducing them to defined-outcome ETFs, or buffer funds.

So, what are the pros and cons of investing in defined-outcome funds? Who are these investments best suited to? And what do you need to know about them before investing? Joining me to share some of the key questions to ask your advisor about investing in defined-outcome ETFs is Jason Kephart. Jason is Morningstar’s director of multi-asset ratings. Nice to see you, Jason.

Jason Kephart: Thanks for having me, Susan.

What Is the Promise of Defined-Outcome ETFs?

Dziubinski: All right, let’s start at the beginning in broad strokes. What are the promise of defined-outcome ETFs?

Kephart: Yeah, so the promise is pretty simple, and it sounds almost too good to be true. You’re going to get a certain amount of upside of the stock market with a very limited amount of downside. So, maybe you’ll get up to 5% upside and maybe only like 2% downside, which could be attractive to some people.

How Do Defined-Outcome ETFs Work?

Dziubinski: How do these funds work, and what do they invest in?

Kephart: So what they’re investing in is basically a basket of stocks, usually the S&P 500 or a large-cap index, though there are variations. What they’re doing is they’re using options to kind of trade around that. So usually they’ll sell call options to kind of cap the upside, but they’ll use that premium they get from selling the call option to buy a put option, which gains value when markets lose money. So that’s how you kind of get that neutral zone of your returns you can expect.

What Is the Outcome Period for Defined-Outcome Funds?

Dziubinski: Now, these funds are called defined-outcome funds. So what is this outcome period for these funds? Is it always one year?

Kephart: It’s not always one year, though that’s the most popular one we’ve seen, but it can be two years. It can be six months. It’s really important that investors read the fine print on these because that time frame is really important. Because that’s the only time the defined outcome is really in effect. And you’re holding it longer, it may reset. If you’re buying it in between those periods, you may get a different outcome. I think it’s really important to know what you’re getting into before you buy these.

Limits on Gains and Losses in Defined-Outcome ETFs

Dziubinski: Now, there’s a limit to your gains in a defined-outcome fund, but there is a floor to the losses, too?

Kephart: Yes, so usually there will be a cap. It can be, “we say you won’t lose any money,” but also it can be, “we will cap the downside at 10% or 5%.” It really varies, but with options, there’s like no limit to the way you can structure these things. So again, there’s a lot of variety. We’re seeing a lot of product launches. So it really is buyer beware with them because I think even though the outcome is probably going to work out in the end, they can really easily be misused.

Are There Mutual Fund Versions of Defined-Outcome Funds?

Dziubinski: Yeah, it sounds like a lot of complexity. So are all defined-outcome funds ETFs or there are mutual fund versions, too?

Kephart: There’s a handful of mutual fund versions, but predominantly it’s ETFs. Of the 389 defined-outcome strategies in Morningstar’s category today, I’d say the vast majority are ETFs.

Average Expense Ratio for a Defined-Outcome Fund

Dziubinski: Jason, are these expensive funds to own? What’s the average expense ratio for a defined-outcome fund?

Kephart: There’s always a catch, right? And these ETFs are more expensive than you probably think, especially if you’re capping your upside at 5% or 10% to the stock market. The average expense ratio is about 80 basis points. The cheapest ones are around 50. The most expensive ones go up to about 100 basis points.

History of Defined-Outcome ETFs

Dziubinski: Jason, talk a little bit about the history of defined-outcome ETFs. Are they somewhat new, and how popular are they?

Kephart: They’re not new, but we’re definitely seeing a lot more of them being launched and a lot more interest in them. In October 2023, Morningstar launched its defined-outcome category in response to the client demand we were seeing. Of the 389 that exist today, more than half of them have been launched since 2023 and over 100 have been launched in 2024 alone. Assets have grown to about $46 billion as of the end of October, which is about double from where they were a year before. So we are seeing a lot more interest in this area.

Why There Are So Many New Defined-Outcome ETF Launches

Dziubinski: So that seems like a lot of launches. Why so many?

Kephart: I think it’s part of the way they’re structured. Usually they have a one-year period. That’s the most common we’ve seen. So an asset manager will launch one that starts and ends every month. So there’ll be a January version, a February, March, April, May, etc. version. So when they’re launching one, they’re usually launching like 12, so you could build a ladder of these. But really, that’s where it really depends—you need to know your starting and end point to really use these effectively.

Who Are the Main Asset Managers for Defined-Outcome ETFs?

Dziubinski: Jason, who are some of the main asset managers or players in this market? Any familiar names?

Kephart: Not as many as you’d think. It’s a lot more-niche players. So like First Trust, which is popular in the ETF space. Also Innovator ETFs. IShares has launched some recently. That’s kind of the only one of the really big ETF providers that’s dipped a toe in the space so far.

How Defined-Outcome Funds Performed When Markets Decline

Dziubinski: During market declines, how have these defined-outcome funds performed? In other words, do they work when you need them to?

Kephart: I think because more than half of them have been launched since 2023, we really haven’t seen a shock period for the majority of them. The few that were out in 2022, depending on where they set their floor, they kind of delivered as you’d expect. Put options are pretty reliable in the way you can structure them. So you really can get that cap or bottom floor. But I do think most of them really haven’t been tested yet.

Advantages of Defined-Outcome Funds

Dziubinski: What would you say are the pros, the advantages of these vehicles?

Kephart: The pros are you’re kind of getting what you pay for if you use them correctly. If you buy it in January and you hold it till January, you’re going to get a return within that band that’s kind of promised to you. So I think they are predictable if you’re using it tied to the time horizon.

Disadvantages of Defined-Outcome Funds

Dziubinski: And then what are some of the cons?

Kephart: The cons are, I think, they could be hard to use correctly. You really do have to line up your time horizon with the way the time horizon is built in the product. Then also there’s always the classic FOMO. If you’re capping your upside and the markets are raging, a lot of people might let animal spirits take over, sell out, chase the market. And so I do think the biggest risk with these is misuse and people just buying them for the wrong reasons and then kind of like, you don’t want insurance when the sun is shining.

Who Are Defined-Outcome ETFs Good For?

Dziubinski: Yeah, not sticking with it. Right. OK. So then what type of investor would you say that these vehicles are good for?

Kephart: I would say more-conservative investors, maybe investors who have oversaved. They’re on pace to meet their goals, and maybe they can afford to give up a little upside for that peace of mind of capping the downside.

How Do Defined-Outcome Funds Fit Into a Portfolio?

Dziubinski: I know you’re not a portfolio strategist, but I’m going to ask you anyway, how might defined-outcome funds fit into a broader portfolio? What’s their role?

Kephart: Yeah, I think they’re kind of a fixed-income alternative. There’s not a lot of interest-rate risk in them. So if we do get another inflation shock like we’ve seen in 2022, that really shouldn’t impact them too negatively. So I do think like as a fixed-income replacement, that’s where they kind of fit in. But I do think there’s still benefits to owning classic bonds—you know, you get the income, you’re not going to get income from these. Also, when things get rocky, bond duration can be a really good diversifier. So that’s another thing that I think—bonds still have a very solid place in a portfolio.

Ask Your Advisor These Questions Before Investing in Defined-Outcome ETFs

Dziubinski: If an investor is saying, “All right, Jason, well, this sounds pretty good. Maybe it’s for me” or they’re hearing about it, say, from their advisor, what questions should an investor be asking their advisor before diving into one of these?

Kephart: How are we going to use it in the portfolio? How is this going to meet my financial objectives? Is it because we’re overfunded? And if we’re overfunded, are there other things I should be thinking about? Also, how should we think about the higher fees? What’s the trade-off there? And is it really just that we’re concerned markets aren’t going to pay off, that we need to give up some of the upside because we’re bearish? I think you want to just understand exactly why an advisor is approaching you about this. Make sure it’s not just because they saw a cool story in The Wall Street Journal about them.

Dziubinski: Got it. Well, Jason, thank you so much for your time today. We appreciate it.

Kephart: Thanks for having me.

Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.

Watch Ask Your Advisor These Questions Before Investing in Private Credit for more from Jason Kephart.