Innovator’s Ashenden on Risk-Managed Exposure

I mean, if you look at the category, I mean, it didn't exist a few years ago and now we're looking I consider it like a fifty billion dollar category for buffers overall. So no matter how you slice it like this has been a smashing success and honestly like this is something that our team has been looking at and covering for a long time now. But yeah, this this is finding its home in the ETF industry and it's doing really well.

I love that fast paced environment, competitive atmosphere. And you know, Virtuo Financial specializes in ETF trading, so our desk did a lot of arbitrage ETF trading, ETF block trading, so more of a technical start, I would say, on the ETF side, and it kind of gave me a background grounded in ETF pricing, how the ETFs are structured, but also got a little bit of a glimpse into how to launch an ETF because you're the l m M or lead market maker and typically provided c capital for

a lot of ETFs that were brought to market. So after Virtuo Financial, I kind of went over to the dark side, as we like to say, the ETF issuer side, and went to Direction ETFs and that's where I got my first taste of derivatives within the ETF rapper. Direction specializes in the leveraged and inverse funds, a really interesting firm. I'm on the forefront of innovation there, but focus more

on the tactical trading crowd. But you know, I saw there kind of the writing on the wall that derivatives in the ETF rapper were still in the early stages. You could use them to leverage returns accelerate your upside, but you could also use them to insert protection in the ETF rapper. So you know, from there I got put in touch with more of a startup ETF firm innovator Capital Management was the name. They were based in Wheaton, Illinois.

I was looking for an earlier stage ETF firm and got put in touch with them and ended up being sort of the first product hire undergrad Day are now CIO and we can talk more about Innovator in a second. But we're doing some pretty disruptive stuff over here.

They went into retirement pseudo retirements, and one of them was pitched a structured note in retirements, and that's where the story gets really interesting. The light bulb sort of went off and they said, you know what, there may be a better way to package this risk managed exposure that we see in structured notes ryla's annuities, that type of risk managed exposure that's typically only existed facing a

single counterparty like a bank or an insurance company. How can we deliver that kind of exposure in the ETF wrapper? And we know you know, you guys know this better than anyone. The ETF rapper delivers liquidity, tax efficiency, transparency, lower costs. So really Innovator's mission is to disrupt the structured product annuity hedge fund industries by trying to provide superior outcomes in the ETF rapper for those reasons that

we mentioned before. So our entire business is built around delivering risk managed payoffs in a very easy to digest, inexpensive, transparent rapper.

Amplify ETFs, which also bought another ETF firm, is based there. So there's a lot of people from coming out of Wheaton College and Illinois that are based in the ETF industry.

So defined out COMEDTF isn't really anything new, right, Like, these types of payoffs have existed in the structured note rapper for many years, but we simply kind of shepherded that exposure over into the ETF rapper. So there's three things that you need to know when you're talking about a defined out COMEDTF. The first this is BTF has an outcome period, so that's a specific set of time. It could be three months or a quarter. It could be one year, it could be two years. That is

the time over which the defined outcome exists. Then you have your protection that could be a buffer or a barrier against losses, which we'll talk about more in a moment that cushions you against losses, protects you in the fifteen percent buffer example I gave that buffers you from zero to negative fifteen percent. So over a one year outcome period in the ETF, a tick orrell I'll throw

out is poct. That's our fifteen percent buffer on the S and P five hundred that ETF is designed to deliver you point to point exposure to the S and P five hundred its price return over one year with a fifteen percent buffer against losses. And then the third component that I'll mention is there's an upside cap, so

there's no free lunch with the product. Even though you have a buffer against losses, you're going to have a cap on the upside So if the market finishes down twenty percent at the end of that one year, you're going to be down five percent in the fifteen percent buffer ETF. If the market is down ten percent, you're buffered. You're completely covered. The buffer did what it was supposed to do, and you were flat. Now on the upside, you're going to track one to one with the price

return of SPY. So let's say you have a twelve percent upside cap in that ETF. If the market's skyrockets and is up thirty percent over that one year, you're going to hit your cap. You're going to be capped out, as we like to say an innovator, and your return is going to be twelve percent. But if the market finishes up five you're going to be up five. You're going to track one to one with that ETF over

that outcome period. So again, outcome period, protection level, and upside cap or those three core components.

barrier income ETFs. That's a very popular type of structured notes, and again we're bringing that to the ETF rapper. Now that type of solution offers a set amount of income on the upside, so we sell options you have a set income level on the upside, so you're not going to track the price return of the index. You're just going to have that set income level. But your protection

is a barrier. So a barrier is a little bit different than a buffer in that the barrier is protection in place, but if you fall below the barrier, you've now assumed all losses, including up until the barrier and beyond the barrier. So just put some numbers to it. A fifteen barrier, if the market finished down twenty, you're going to be down in twenty because you kind of

locked into that barrier. You're taking on all the losses once you went through the barrier level Versus with a fifteen buffer, if the market was down twenty, you're just going to be down five. So you can imagine since there's more risk with the barrier, you're compensated a little bit more on the upside. But to be honest with you, James, you know most of the assets are in the buffers, most of the interest is in the buffer space right now.

But we are beginning to see interest in barriers and accelerated.

things longer than leverage on a daily basis. So those direction products that offer you three times a return of something or inverse return, it only tracks it for a day. You guys are going the opposite where like you're kind of only offering this thing over year. Like, are you seeing interest in other areas of those outcomeperiods?

there's a more frequent reset. So advisors, for instance, if they buy a one year outcomperiod and let's say the market moves up three months in the market's up ten or fifteen percent, that ETF that is a one year out comperiod has now moved up and has experienced some of its cap into that one year out comperiod. So if you were to buy into that ETF three months into the one year out comperiod, you actually now have a little bit of downside right and you have a

little bit less cap. So that's why we typically see volume cluster around the beginning or the end of the

outcome period, at least for our annual products. The reason we've seen quarterly outcome periods explode in popularity these are tickers like balt b alt zalt zlt is because of that more frequent reset, James, And that's that's really useful because advisors have money coming in throughout the year, so they don't necessarily always want to worry about do I buy this specific annual outcome period that's resetting in March. Do I need to buy a different annual outcome period

resetting in August. Instead of lattering those they say, you know what, I'm just going to use a quarterly outcome period product, and when that money comes in throughout the year, I know that in the next month, two or three months, it's going to be resetting and getting a fresh downside buffer and a fresh upside cap.

the liquidity, the tax efficiency, the reset. So I'm going to double click on the reset here because it's really cool. We talked about outcome periods. What separates these ETFs from a traditional structured note. So at the end or xpery of a structured note, let's say it's one year, two years, or five years or six months at xpery, that is

a taxable event that note comes due. That is a taxable event for the investor or the advisor and their client with the ETF at the end of the outcome period, at the end of that one year or three month out comperiod, it resets within the wrapper. So what that means is we're going to roll the exposure at the end of one year, and we're going to move into a new basket of options with a one year xpree. That process of either selling we're letting those options expire

if they're in a lass position. In rolling into a new options basket is not a taxable event that occurs within the ETF wrapper. So it's not tax avoidance, it's tax deferral. We're deferring those gains to the future. But the benefit for you is the investor, is when you buy that ETF at the end of that outcome period,

there's nothing that you need to do, absolutely nothing. You're going to get a fresh buffer and a fresh upside cap and you can hold the ETF in perpetuity and you decide when you want to experience that taxable event when you sell the ETF. So what actually happens behind the scenes on that reset day To answer your question, we move in and is that ETF approaches the end

of its outcome period. On the final trading day of that outcome period, we close out that basket of options typically four options, which we can get into in a moment, and we roll into a new basket of options with a new one year expery and then even though these are classified as active ETFs, there's really no active management

that's occurring. It's all systematic in nature. So once we strike those options at the beginning of the outcome period, that set of options with that xpery and those strikes are not going to change. Those will going to be the exact same options for the entirety of the outcome period. The only thing that's going to change is the quantity of the options in the basket when we see creations or redemptions in the ETF.

to one exposure to spy. You're going to have your protection, which is a put spread, typically an at the money put and then another puts sold about fifteen percent lower, and then we have a call on the upside that we sell, and we sell that call on the upside and that's what sets our cap for the outcome period. We're going to sell that call at the highest level that we can to set the cap that will perfectly finance the protection or the buffer that we have in

place with those puts. So typically four options in that basket. They are exchange traded in their flex options, So flex is easy for your listeners. Flex is flexible. What that means is that we can customize the tenor we can customize the strike price. And the reason that we do that is we want to be able to communicate a perfect fifteen percent a perfect thirty percent buffer for our clients. And you know, putting on my market making have for

a second. You know, these these ETFs and these options trade very similarly to like a listed option, So a flex option is really eased to hedge those market makers that are out there they've told me. It's kind of like a Swiss army knife. Of ways that you can hedge our ETFs. You can use spy, you can use spy options, you can use index options. The critical takeaway for your listeners is that the basket is hyper liquid.

If you look under the hood of these ETFs, you'll see a basket of flex options tracking the most liquid equity benchmarks in the world. So spy iwm q's efa ee M, we're tapping into all of those liquid benchmarks with our flex options. So don't be to turn if you look into the basket and you see options. Remember

they're tracking the most liquid benchmarks. They're very simple to hedge, and the proof's kind of in the pudding because if you look at the ds on screen, James, you'll see they're like fifteen to twenty basis points, which is super tight across the ETF landscape for ETFs.

it stands for requests for quote. And one of the things that we did when I was a trader on that desk is we were getting quotes from people all day long, people paying us saying I need to buy fifty thousand shares of this ETF eighty thousand shares of this ETF, and those quotes would hit the market making desks and they typically would put market makers in competition when an advisor or an institution wants to purchase a big block of an ETF, So our job as a

market maker was we have to give them a competitive quote. The problem was is that ETF became really popular and everybody wanted a quote all the time. So what we did was we found a way to automate the response to RFQs a request for quotes. And now if you look across the ETF marketplace, if we have advisors on the call, if they custody at Schwab or the custody

at Fidelity, that entire process is automated. They go to their block desk at one of those custodial firms, or if you're an institution, you go to a custodian or a market maker and you can get a nearly instantaneous quote back on an ETF block trade, and that's because of the automation of the request for quote process. So options,

it's a relatively similar process in what we're doing. We go out there whenever we reset the funds, and we use an auction, and we go out to five or six different option market makers and we request a quote on the options package. And this is a cool caveat. We actually trade the options as a package. Instead of going out there and trading each individual options, leg Innovator goes out and gets a quote on that entire options package.

And the thing I like to say is that we have economies of scale and we actually have the attention of these big options market makers like Susquehanna, Old Mission, Goldman, Sachs, Jane Street. So what we found is that we're actually able to get a significantly higher cap for our investors than if they tried to do this on their own. And that's what I talked to about with institutions, pensions, endowments.

We say, you know what, you can try to mimic this yourself, but you'll typically get a lower cap than you would get if you use the innovative product because of our economies of scale. And to top of that, David and James, nobody wants to manage options. That's the feedback that we've gotten. It's Harry. It creates operational difficulties. So if you can get that risk managed exposure in the etf rapper, it's a win.

You said you can get a higher cap, but like, can you go into like the math of why you can get a higher cap than most individuals and like what goes into calculating that?

dollars in options each month. I mentioned spread costs before, So James, if you were to go and buy options on screen right now, you could see what that spread cost would be, and you'd have to calculate the spread of the listed options for each individual leg We typically are going to pay around twenty to thirty percent of that spread cost, which means that we have more options budget to spend on that specific package, so we're paying less and spread cost that's going to contribute to a

higher cap. On top of that, we typically get superior pricing on a fifteen percent buffer. We recently modeled that we get between one and two percent, so around one and a half percent. We'll call it higher cap than if you tried to do this exact same payoff yourself using listed options, So a significantly higher cap that not only is larger than the management fee that we charge, but also just gives you additional upside for your investors. So I would say spread cost is a main determinant.

Economies of scale is another determinants in generally those market maker relationships that we built over the course of the past six seven years of doing this are a large contributor.

say this ETF underperforms. But I think there's kind of just a fundamental misunderstanding of what the investment objective is of the ETF. It's designed to deliver risk managed exposure. It's designed to deliver that defined outcome. If you move below the buffer, James, yes, you're going to take on one to one downside, but you're still going to outperform

if you had just held unheadged equities. So you know, from my perspective, the risk managed, the risk managed exposure is built into the structure, and I think folks that have usedtructured product, they get that, they're familiar with it. Another thing that's come up, James, is what if we buy the ETF in the middle of the outcome period. What if we buy it at the wrong time, what if we buy it in the markets up, I buy it six months into the twelve month outcome period and

I have downside. And we, as kind of the pioneer in the space, have put a ton of effort into our website and our tools. So if you go to our website, I would encourage folks to go to innovator ETFs dot com. We've designed five different tools, a potential outcome analyzer, a previous outcome analyzer, a personal outcome analyzer to help you make sure that you're getting in at the right point the outcome is exactly what you would expect it to be and avoid any of those situations.

So those are the potential pitfalls that we've heard raised, but those are easily addressable if you use some of our tools.

but you guys are still pulling in assets. I guess, like, what are you seeing people actually doing in the allocation side of this, Like where are they taking it from? Are they taking it from an alts bucket? Are they take it from the equity bucket fixed income? Like what what are you seeing happening? And what type of allocations

are we seeing? Because I would say like people should not be substituting their core equity exposure with these things, But it makes sense in some regard like to take maybe some of it if you're worried about risk over the next year term or something like that.

to put it into a buffer. Then we saw rates go up, right, and something really interesting happened, James, and this is why our product suite really can stand the test of time in volatility and rates. When rates went up,

certain segments of our suite became very appealing. So, for instance, we launched the first one hundred percent buffer ETFs last year, which is basically a principally protected note equivalent in the ETF wrapper, and rates were a key determinants of the upside cap in that ETF, so you were able to get around a nine to ten percent upside cap to the s and P five hundred with full principal protection, which was around two times what you were getting in

treasuries at the time. So the rate environment actually helped products like that, and we saw one hundred percent buffer ETFs used as sort of a cash substitute, cash compliment, get that cash off the sidelines, but in sort of a core allocation. Where does it fit We view these

ETFs for conservative investors, pre retirees, retirees. We see folks pulling our thirty percent buffer or our bolts, our quarterly twenty percent buffer, taking some of their bond exposure and putting it in that highly defensive buffer ETF to get more upside. The key thing to James Is and David is taxes. This is something that keeps coming up. There are ETFs now in the marketplace that it will not be named, that are almost designed for that purpose to

deliver you just the price return and avoid that. It's a nice consequence of the buffer ETFs that we are not paying the dividends. We actually use that dividend to finance a higher upside cap for our investors, So we don't ever intend to pay out any sort of capital gains distribution in the fund. These funds are designed to deliver that price return, and that's intentional because clients don't want to pay taxes. They want to insulate that they want to defer taxes in the fund until the future

points and that's the benefit of the buffers. So James I would say hadged equity conservative equity bond replacement. We kind of see it run the gamut depending on the buffal level.

you seeing demand? You're seeing demand anywhere other than the S and P five hundred. Are you going to hopefully are you looking to launch other products at some point tracking underlying different underlying indices?

We recently launched quarterly outcome periods with a ten percent buffer on all of those. And to be honest with you guys, the growth there is accelerating even faster than the S and P five hundred complex. Over the past two years, each of those reference assets, just to put it in perspective, is approaching around a billion dollars, so a lot smaller than the big pie, which is fifty billion. But the reason that people are buffering those indices is

that they've typically underperformed like the small caps. Like people have. People have been trying to time small caps for a long time. Advisors have been in institutions, have been a little bit tenuous when it comes to investing in those. So we say, if you're considering it, use a buffer avoid market timing, and if you're incorrect, you have that built in protection in place.

the future of buffer ETFs? And you know, part of that is, you know, could there be a situation where there are flex options on other types of indexes, even you know, maybe smart beta you know, to try to you know, do a buffer on a smart beta index, or you know, just general predictions for the future.

drives the majority of our product. Looking at the numbers, David, So around three hundred and eighty billion, I think was the number last year in annuity sales across growth and protection hedge funds. Don't even get me started. I think there's like three trillion across the hedge fund space. Rylas, which are more of an index linked annuity type product, those sold about fifty billion last year and they're growing too.

This year. I think the expectations are that those numbers are going to be twenty to thirty percent higher than they were in twenty twenty three. So what does that tell me? That tells me that if the structured note world is still selling like hotcakes, we think we have a better mouse trap that's more transparent, scalable, better for advisors and institutional practices at Innovator. So you know, the space is at fifty billion right now. I can you could add a zero, I think to that AUM in

the next five to ten years. If we get to the place that we want to be in terms of investor education and delivering on what we're supposed to.