New buffer ETF targets structured product industry

First Trust has unveiled its new “buffer” ETF that it believes offers investors unique downside protection in a crowded Canadian market.

The First Trust Cboe Vest U.S. Equity Buffer ETF (TICKER: AUGB.F), which is now listed on the TSX, is targeting the high-fee structured product industry, which Karl Cheong, the firm’s head of ETFs, believes is ripe for disruption.

The decision to come to market with an ETF that offers exposure to the S&P 500 but with built-in downside protection of 10% is also based on the desire for investors to preserve their hard-earned investment gains over the past decade while still participating with the upside of the market.

Cheong said the new offering is a truly unique product after a period where manufacturers have mostly competed on price and increasingly narrow segments of the market such as marijuana.

He said: “This is completely different to anything else in the Canadian market. There is nothing available to retail investors that can give you a defined outcome after a year.

“Most investors investing via index-based equity ETFs are generally exposed to the price fluctuations of the market - with little or no downside protection. This is the only product on the TSX with a defined outcome. You know exactly what your performance will be depending on the price performance of the S&P 500, which helps with financial planning and forecasting."

If the market is down 10% or less, clients will get their money back net of fees. In a time of “Trump risk” and given the current stage of the cycle, Cheong believes the product is timely. First Trust has filed for two different buffers, 10% and 25%, which it plans to launch on a quarterly schedule.

So, if the market rallies 20% and the cap is set at 13%, why would an investor hold the product? That’s when, Cheong explained, an investor can move between different buffer ETFs in order to participate fully with a market rally while maintaining a buffer against market declines, with the company hoping to expand its quarterly launches to monthly if successful.

For example, if a trade deal is suddenly struck, then clients can switch into the November series of the 10% buffer and still participate a lot more on the upside with a new cap and buffer.

The ETF, which uses four options, seeks to address the inherent flaws around structured products like high commission, lack of transparency, interest rate risk and the inability to bulk trade across client accounts. Other key features include its lower relative cost of 85 basis points, 1:1 upside to cap, intraday liquidity, no counterparty risk, capital gains treatment, currency hedged and a risk-rating of low to medium according to its prospectus.

It is rebalanced annually, has one-year outcome periods and Cheong believes AUGB.F offers advisors an ideal capital preservation tool.

“We see these products not hitting home runs but hitting the singles and doubles. They are safety tools with the opportunity to capture the upside.”

The product is positioned as a replacement for S&P 500 ETFs or other equity holdings or as a bond or GIC replacement given compressed yields.

Cheong added: “If we continue to see a flight to safety, you may have further appreciation in bonds, however given current interest rate levels, an investor will not be able to hedge themselves fully against an equity market decline of 10% or more by simply investing in fixed income. It is simple math."

While designed to be an effect replacement for structured products, the ETF series will also go up against alternative buckets.

Cheong said: “You can buy this ETF and know exactly what your outcome is relative to the S&P 500 at any time – that is not something a mutual fund or hedge fund manager can say with any degree of confidence. Furthermore, the hedge fund industry has been relatively - compared to mutual funds - unblemished by the ETF revolution despite the notoriously high fees and underperformance relative to the S&P 500 over the last several years.

“We believe this product adds tremendous value to client portfolios. It provides investors with peace of mind that they will be able to participate with the upside of the market while conserving wealth should the market correct."