How Do You Protect Against Market Drops?

Welcome to "The Informed Investor." Today's topic is "Managing Downside Risk "in Your Stock Portfolio." I'm Mark Gochnour. I'll be joined today by Dr. Wes Crill and Jake DeKinder. Guys, I always like to start with a couple headlines, and then we'll dive into it here. So two headlines. The first one, "Buffered ETFs Protect Against Market Drops. "They Are Selling Like Hotcakes." And then the second one, "Buffered ETFs Do Their Job, but Are They Worth It?" So some great headlines here to open up the conversation. Maybe we start with the hotcakes. What's a hot cake? Well, I think we decided it's the same thing as pancakes- We did. Flapjacks? I think we looked that up, right? Yeah, yeah, I don't know why we need so many different ways to describe a very bland, basic food, but here we are. I think we also looked up that going all the way back to prehistoric times, this has been a staple of human diet, but we don't know what they called it back then. Yeah, that was a pancake back then. It's evolved- I mean, did they call it a pancake? Was there formal language back then? All right, it does reference though, the buffered ETFs. So Wes, let's start with you. Just give us a little bit of overview of kind of what buffered ETFs and how do they fit into some of these broader strategies we hear about with minimizing downside risk? Well, first of all, the idea of minimizing downside exposure sounds great, so you can imagine the appeal associated with these. And to your point, they've been very popular this year. They've seen $38 billion in terms of net new flows to the categories that would be categorized that way in terms of downside protection. 97 new ETFs have already been launched this year across those categories. So again, it's just a general class of investment strategies that really are seeking to minimize their downside exposure to fall less than the broad market, I guess, is the way you would describe it. Well, and it's really nothing new, I'll say, in the industry. I mean, what are you doing there? You're really managing the emotions of an investor. You're kind of managing fear and greed is what these strategies are designed to do, right? I mean, it's very appealing to say, "Hey, I'm gonna help you out, "and I'm gonna protect you on the downside, "but I'm gonna still give you "some of the stuff on the upside," and we'll go into some of the details on it. But these types of products of, I can design basically a service for you to manage your emotions, that's been around for decades in this industry. Well, I like how you said, it's nothing new, but go back to maybe some of the reasons why it seems pretty popular right now. I go back to 2022, which was a really tough year for investors. You had stock market was down here in the US, bonds were down, so a really tough time period when both of those were down significantly. A lot of times people think, well, when stock are down, bonds will do well, so I think part of it is that, that maybe somehow things are different because of that one year's experience. You still hear a lot about all-time highs, and that gets people a bit nervous, and we just did an episode about all-time highs, so folks can go listen to that one as well. Nice promotion. Yeah, great promotion there. And then, part of these categories can kick off some income, and some people think, well hey, I can get downside risk, yet I can still get some income in a portfolio. So, Jake, it's kind of what you're saying there. It's marketed as a way to solve a lot of these different needs, but let's dive into it a little bit here and think about are they really efficient at what they're supposed to be doing and are there other ways to think about minimizing risk? Well and the risk thing is really key here, because just because you're invested in these strategies doesn't mean the risk goes away when it comes to stocks. Somebody's holding these stocks. Somebody's bearing the risk. So you can think of these as maybe being approaches towards transferring some of that risk to someone else. Now, people might be willing to do that, but they're not gonna do that for free. And in fact, the cost associated with that is likely to vary depending on what the circumstances are. We know from looking at options pricing data that when uncertainty is higher, the options markets are going to give you a higher price to transfer your risk. And so, those are gonna factor into potentially the performance of these. And I think that makes 2025 so far an excellent test case, because we did have a big market downturn back in April and then a really quick rebound. And so, you're thinking about not just, you know, what is the possibility that can stem some of the downside from markets, but then what am I giving up in terms of upside participation? How is that gonna come back to bare itself when there's a rebound? Well, you're talking about there's risk that has to be born, and what are they gonna charge you to do it, right? Obviously, the other side of that is there's return to be had, and who's gonna walk away with that? So almost as an investor, you kind of have to push yourself and say, "So wait, someone's gonna allow me "to get some type of better return for a lower price, "or they're gonna do it for free." Just remember, everybody in this industry is a for-profit player, right? And there's return that is gonna take place out there. Ask yourself, as an investor, "Who walks away with the return?" I think about that transferring risk, it's like home insurance. I mean we get it. Somebody else is bearing that risk, and then there's a cost to us for them to bear that risk here. But, Wes, let me read a couple different categories here, and I'll get your thoughts. Maybe just give us an overview of the way that they try to manage risk here. So, I think the buffered ETFs would fall into a category called defined outcomes. There's equity hedge. There's derivative income, some of these different categories in Morningstar, but ultimately, I think they're trying to accomplish the same thing, which is minimize some of that downside risk. How do they do that in those different strategies? Yeah, without getting into all the technicalities of it, you're using different kinds of options with buying some, then selling others to potentially stem the losses if there is a falling market. It's not a guarantee. These are still investment products. But what it means is to a certain point, you might mitigate some of the downside of the portfolios. But then there's that combination of the different options, which means you're probably gonna be giving up some of the upside. And I think again, investors have been trying to balance their participation in the upside with the potential for downside for as long as we've had investments. I think that's one of the appeals to having a potential balance type of strategy where you have equities and fixed income that's meant to achieve a similar outcome. And I think the development here is people are trying to do this within the equity sleeve of their portfolio, and then that remains the question of is that the most effective way to get your downside protection? Jake, you were talking about earlier this idea of ease of access and how, in the past, maybe it's a little more difficult to go get some of these different strategies, but now with some of these ETFs, you can just go out there and and buy it pretty quickly. Well that's just it. I mean, go back to the old fixed annuities. Go back to the old structured products where you have some type of fixed income return, and I get a derivative overlay on it. And I basically can sort of define, try to define what I want that outcome to be. What we have seen, and I think you referenced this in terms of the flows, now what you've moved from is, I don't wanna say a product that maybe was hard to get, but maybe the ease of access wasn't the same as when it's traded on an exchange in an ETF vehicle and maybe marketed a little bit more to investors. And listen, this ease of access to investment options, I think that's actually a really good thing for investors, but you have to know what you're getting. Just because it's packaged in an ETF format doesn't mean that there aren't risks that are associated with it. And no matter what, you gotta understand what it is you're investing in and is that the best way to accomplish your goals? Well one of the things we talked about is there's a cost to going out there and getting this insurance. Let me read a couple numbers here for you guys, and I'm gonna highlight the three categories that we just talked about, just because it covers a lot of those different strategies. Now this is the expense ratio, so the cost to the shareholder, what they're paying, these different entities to do this. So, the derivative income category, the median expense ratio of all those different funds in there is 97 basis points or 0.97%. The equity hedged is 1.07%, and the defined outcome is 0.79%. So, expense ratio is larger than what we see in, I'll say, the average mutual funds that are out there. But let me highlight some of the returns as well. And I'm just gonna go back to the last three years. It's an interesting time period where you go to 2022, which was that challenging year. I think the S&P was down about 18% that year. And then we'll look at the following two years, which were some pretty good years in the market. So these are gonna be cumulative returns of those three years, 2022 through 2024. The derivative income cumulative return is 21.5%, equity hedged 18.3%, defined outcome 20.7%. So those are three good numbers there, but if you look at the S&P 500, cumulative return was 29.3%. So it goes back to the strategy then of what they were doing. They certainly minimized the downside in 2022, but they missed some of that upside or gave up some of that upside in the subsequent two years. So it doesn't necessarily seem that it could have been the best solution perhaps over that three year time period. Well, they're striking a trade off, and I think, again, whenever you think about whether something's appropriate for your asset allocation, there's a number of things you might evaluate, but one of them is, am I getting something that I can't get elsewhere? And if I'm not, then you start to think about those expense ratios, right? So we already talked about the idea that you can sacrifice some of your upside by taking a little bit less on the downside with equities and fixed income. Well, we know that can be done relatively inexpensively. And so, when you talk about those expense ratios, you might say, "Well, "is this worth the additional cost, "potential additional complexity "in something that I may or may not understand "versus just stocks and bonds if I'm not ultimately "getting a better outcome over the long haul?" You brought up insurance, right? I mean, people complain all the time about their premiums going up, and there's reasons for that. We don't need to get into natural disasters and all of those things, but that's the reality. People are like, "Is it worth the cost? "Man, these premiums are getting really high." And I think for some of these products, you wanna think about it really kinda the same way. One of the things that we talk a lot about, and there's a framework here, we use it at Dimensional, it's really effective to evaluate any investment that you're considering. Now, Jake, walk us through just those four parts here, and then we can kind of see how some of these different buffered ETFs might fit in. This is something we've talked about for a number of years now. I mean Gerard came up, Gerard, our co-CEO and CIO at Dimensional here. I just think it's a great framework to think through really any time you wanna put money to work. And the first question you want to ask is, "What's the goal?" What is it that it's accomplishing for me, as an investor? Next, you want be able to think about what's the expected return, or, in plain English, what do I think I might make on this investment? 'Cause by the way, if you wanna do any type of financial planning and scenario analysis, you gotta come up with some expectation of what you think you're gonna make, what's the risk that's associated with it? And that, by the way, for a lot of things goes well beyond volatility. And then what's the cost associated with it? And with cost, you wanna think about the expense ratio, you wanna think about something like tax costs, and then you want to think about opportunity costs as well. That's one to always remember. 'Cause unless you have unlimited money, you're pulling money out of X and you're putting it into Y, and there has to be some form of an opportunity cost potentially associated with that. Those four questions are really good to keep in your mind as an investor. It's great for any investment. And Wes, to me, it points to a couple different things here. You think about what's the goal of stocks. I think for many people it's, I want to grow my wealth over time, but then there can be a goal from another investment to help minimize some of that downside risk. And maybe that's where the conversation that brings in bonds and how can you think about using stocks and bonds in your overall portfolio? Yeah, that's again, if you're trying to assess whether this expands your opportunity set, what other asset classes do you have already at your disposal that can help you balance your upside versus downside, like you mentioned bonds. 2025 has been a good test case, like I mentioned earlier, because we had the draw down in the broad market, but then the rebound. So if you look at the performance for a global 60/40 index, it actually outperformed these categories that we've been talking about, the defined outcome, the derivative income, and the equity hedge. And so I think that's, again, you go back to the expected return. What do I think I'm gonna get from these asset classes? It's not clear that it's going to be a better way to do it, and then you factor in the costs. You mentioned taxes, that's another really good point, especially these categories that are throwing off a lot of income, like the derivative income category. As the name suggests, it tends to be high yield set of investments, and a lot of times, those can be tax at ordinary income rates. And so if you look at the tax efficiency, basically how much of your on-paper returns are preserved after distributions? It's been substantially lower in recent years than the general equity investment category. You know, we're watching the headlines all the time. We've been doing this for a long time. We've seen a lot of products that are launched. And I'll tell you, over the last couple of years when we're out there, we're talking to financial professionals, we're talking to financial advisors, we're talking to investors, you see trends of questions that come. And we'll go back a couple of years ago. We got a bunch of questions about SPACs. And then we get a bunch of questions about meme stocks, and then more recently, we get more questions about private investments. Now we're getting questions about these buffered strategies. And I guess the way I think about that is when I start to see a lot of questions pop up from financial advisors and almost indirectly, from retail investors, for me it's a red flag. Because then I'm like, okay, now you've got something that maybe was designed or originally marketed to sovereign wealth funds, big institutions, foundations, endowment. Now it's moved down to financial advisors, now it's packaged for a retail audience. And I'm not here to say whether it's a good, bad investment. I just, anytime I see that trend, that is a red flag for me. And again, I think having a high degree of skepticism with the products that can be marketed to investors in this industry is a good thing to keep in mind. I like the word skepticism. Just know exactly what you're getting, Know it, look into it. Yeah. So a couple things jump out to me. One is you think about minimizing risk. If you're pushing that risk onto somebody else, there's a cost for that for them to bear that risk. And I love the framework you walked through. I think for any investment, just go through those four things. What's your goal, expect a return, risk, and cost, and I think that helps give you a lot of clarity in terms of what you're trying to accomplish. And then the best way to accomplish that, which might just be you gotta look at your overall portfolio of stocks and bonds and whatever else might be in there. You just can't isolate it to one particular area like stocks. So what else would you guys add to that key takeaways? I mean, I think one way to think about it is if you're looking for a buffer, think about maybe you already have a natural buffer in your portfolio and when maybe you have periods of time where the US stock market is down, most fixed income asset classes have been up on average. And so, you might not have to look beyond these traditional solutions within your portfolio to manage that downside risk. All right, great topic here today. And we do get a lot of questions around minimizing downside risk of a portfolio. Another set of questions we get is also how do I think about the safety of my money, overall risk of my money, who has it? What are some of the things that are in place? And by things, I mean policies and procedures from the SEC and other areas to make sure that I have comfort that my assets are safe. So that'll be a future topic here on "The Informed Investor." Thanks for joining today and be sure to hit that notification button. Have a great day.