Published by Bob Elliott on Aug 18, 2022 12:46:37 AM
Investors are always looking for ways to reduce their risk while preserving upside. That’s why defined outcome funds are one of the fastest growing ETF segments with 10bln now managed by the industry leader in just a few years. These funds are designed to cap downside (say -10%) in exchange for capped upside (say +15%) at a cost of ~80bps annually in fees.
While defined outcome managers pitch constrained beta as a way to reduce risk, there is one steadfast player in the space diversification. Defined outcome funds incur substantial fees and performance drag while capping big upside years, which tends to outweigh the impact of limiting downside. While it might produce results in any given year, over time investors achieve more attractive returns using diversified active management to reduce their risk relative to an index.
The chart below compares the returns of the S&P 500, a Composite Hedge Fund Index and a simulated SPY defined outcome fund with a -10% downside cap over the last 20+ years (please see the methodology note at the end of the piece for more information). Returns are shown gross of fees to depict relative value of the strategies. All produce the same outcomes as far as returns over the time frame, but the diversified alpha portfolio achieves this while maintaining lower volatility.
The comparative benefit of holding diversified alpha to outperform the index returns seem evident. While all the returns are roughly on par over the last 20 years, the volatility of the Composite Hedge Fund index is more attractive than holding a defined outcome fund.
Source: Bloomberg, Innovator Funds, and Unlimited calculations
It is worth noting that defined outcome funds underperform a portfolio holding stock market and cash to achieve lower volatility. Below is a comparison of the same 10% downside cap simulated defined outcome structure over a roughly 100 year period to the returns of the total stock market compared with holding a 75%/25% stock market/cash portfolio (which roughly matches the vol of the defined outcome portfolio). With the addition of the 80bps fees from the defined outcome portfolio, the returns and Sharpe ratio of the defined outcome fund simulation underperform holding a stock/cash portfolio.
Source: Bloomberg, Fama and French Data Library, Innovator Funds, and Unlimited Calculations
The last 20 years returns shown above appear relatively unusual in the historical pattern of returns. The chart below compares the rolling 20 year returns of the 75/25 stock/cash mix to the returns of the -10% defined outcome structure. Over the last 100 years, the 75/25 stock/cash portfolio has consistently outperformed the defined outcome structure net of fees – and frequently by hundreds of basis points for extended periods. Betting on the recurrence of performance of the last 20 years appears misguided and could lead to significant drag over time.
Source: Bloomberg, Fama and French Data Library, Innovator Funds, and Unlimited Calculations”
Methodology Notes: The simulated returns of defined outcome funds were based upon defined outcome funds pricing data from Innovator Funds over the last 5 years combined with Unlimited assumptions.
Composite Hedge Fund Index – For the net returns, the index is an index is a monthly series which takes the average of hedge fund index monthly returns from BarclayHedge, Bloomberg, HFRI, and Credit Suisse when those indexes are available. The gross index is a monthly series that adds back the estimated fees paid monthly by investors across the hedge fund industry in addition to the reported returns above. Those fees are calculated based on the timeseries of hedge fund fees reported by Bloomberg applied to each index sub-strategy (Equity L/S, Global Macro, etc.). There is an assumption that performance fees are only paid after meeting a high-water mark at the sub-strategy level.
For informational and educational purposes only and should not be construed as investment advice. The historical analysis discussed herein has been selected solely to provide information on the development of the research and investment process and style of Unlimited. It does not constitute an offer to sell or a solicitation of an offer to buy any security. Opinions expressed are our present opinions only. No Representation is being made that any investment will or is likely to achieve profits or losses similar to those shown herein. No investment strategy or risk management technique can guarantee return or eliminate risk in any market environment. The material is based upon information which we consider reliable, but we do not represent that such information is accurate or complete, and it should not be relied upon as such. The historical analysis should not be construed as an indicator of the future performance of any investment vehicle that Unlimited manages.