Stocks that only go up (a little)

Source: Money Stuff by Matt Levine, June 27, 2024

I wrote on Monday about a hypothetical, bad financial product:

1. You give me $100 today.

2. In a year, I give you your $100 back, plus any return on the S&P 500 stock index, capped at 5% (i.e. you get $105 back if the S&P is up more than 5%) and floored at 0% (i.e. you get $100 back if the S&P goes down).

I intended to make fun of this product; this product is a little derivatives structuring joke. The way I hedge this product — the way I produce returns that allow me to pay you back the contracted amount — has nothing to do with the S&P 500. I don’t buy any stocks. I just buy a one-year Treasury bill, which pays me about 5.1% for the year. Then, if stocks are up, I pay you the stock return, up to 5%. And I keep the extra 0.1%. If stocks are flat or down, I keep the whole 5.1%.

Today Bloomberg’s Emily Graffeo reports:

A new ETF is promising a … place to ride it out for the next six months, with none of
the losses if the stock market swoons.

The Innovator Equity Defined Protection ETF – 6 Mo Jan/July (ticker JAJL) will be
the shortest-term 100% buffer fund, an expanding universe of those that use
options to deliver some of the stock market’s gains while promising protection
against the downside.

Over a six-month holding period that begins on the fund’s first trading day on July 1,
JAJL will match the price return of the SPDR S&P 500 ETF Trust up to a cap of
roughly 4.8%. Investors will need to hold the fund for the entire period to receive the
full risk protection. At the end of the year, they can redeem their shares or roll them
into the next cycle.

Hmm: Stock returns with a floor of 0% and a cap of 4.8%. Sorry Innovator! But, no, I’m kidding. My product is bad; Innovator’s product is fine. The trick is that my product offers the S&P return up to a cap of 5% for the year, which is what you’d get on T-bills. Innovator’s offers the S&P return up to a cap of 4.8% for six months. And then, after the six months, it does it again (with a new cap).[4] If you hold it for a year and the S&P goes up 30%, you probably get a return of like 9% or so, which is much better than my dumb hypothetical.

This is fine. Conceptually the way you do this is something like:

1. You give them $100 today.

2. They spend about $97.40 to buy a Treasury bill that will mature in six months at $100.[5]

3. They use the remaining $2.60 to buy a six-month call spread on the S&P 500.[6] That is, they buy a six-month call option on the S&P, struck at today’s price, and sell a six-month call option on the S&P, struck at 104.8% of today’s price. This gives them the return on the S&P index above today’s price, but capped at 4.8%.

That’s economically what’s happening, but the actual mechanics are a bit different: They do all of it through Flex options, essentially buying the entire return profile through equity options rather than Treasury bills plus equity options.

That’s an important point too. When I made fun of my bad hypothetical product on Monday, I said: “You should not buy it; you should just buy the Treasury bill yourself instead.” But several readers emailed to disagree. Their point was: If you buy a Treasury bill, you get 5.1% interest, but you pay taxes on that interest at ordinary income rates. If you buy my dumb product, you get a return of between 0% and 5%, but that return is (probably) in the form of capital gains.[7] If my product runs for a year and a day, it’s long-term capital gains, which are taxed at a lower rate than ordinary income, so my 5% return cap is worth more, to you, as a taxpayer, than a 5.1% return on T-bills.

Even better, if my product runs for longer than that — if, say, instead of giving you back the $105 in a year, I roll it over into a new bet for you — then you (probably) don’t pay the capital-gains taxes until you sell out of my product. If you keep this bet on for 20 years — each year, I give you the return on the S&P 500, floored at 0% and capped at 5% (or whatever the T-bill rate is that year) — then you don’t pay the taxes until the end of the 20 years. And then, when you do, you pay capital-gains rates. Graffeo writes:

Elevated interest rates – particularly at the short end of the Treasury curve – are
helping ETF issuers generate the income needed to offer these kind of funds. While
that also means investors can get high risk-free payouts on Treasury bills, Bond said
the ETF can still provide bigger returns over the six-month period, particularly when
the tax advantages are factored in.

I think that this is part of the point of these buffer funds. The proposition they offer is:

1. You don’t take equity risk: If you put in $100, you always get back at least $100.

2. You get some return that is sort of centered around the risk-free rate: You might get a bit more than 5% per year (if stocks are up), or you might get a bit less or even zero, but you’re not going to lose money and you’re not going to make 30%.

3. That return is taxed more favorably than just investing in Treasury bills. Instead of earning interest on Treasuries, you are taxed like you hold stocks for the long term.

Notice how magical this is. I wrote down, above, how you could structure this product (not how it is actually structured): You buy a Treasury bill and some stock options. The Treasury bill accounts for roughly 97% of the value of the product; the stock options account for a bit less than 3%. But the returns on the product are taxed like stock returns, not Treasury-bill interest. That’s good financial engineering!

We talked earlier this year about another exchange-traded fund, called BOXX (or more formally Alpha Architect 1-3 Month Box ETF), which also used a collection of stock options to achieve relatively risk-free returns. The explicit proposition of BOXX is that you get paid the Treasury-bill rate, but it is taxed as long-term capital gains, and you pay taxes only when you sell out of the ETF and realize your gains.

Since then, various tax experts and Bloomberg Opinion columnists have argued that BOXX’s trade doesn’t work: Tax rules prevent you from, in essence, transforming interest income into capital gains by buying and selling identical stock options.

But buffer funds are probably fine? (Not tax advice!) Buffer funds buy and sell different stock options, different enough that your return is not the T-bill rate but something a bit riskier, a bit more linked to stock returns. Not that much more linked to stock returns — your return here is between 0% and 4.8%, when T-bills would return about 2.7%[8] — but enough.

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[4]

Here is the prospectus; the cap mechanics are described on pages 7 and 8. The cap resets each time based on then-current market prices for S&P options.

[5]

Bloomberg shows the six-month bill as CUSIP 912796ZV4, with a yield of about 5.35% and a dollar price of about $97.42 as of 10 a.m. today.

[6]

Bloomberg’s calculator (SPX Index OV, with default rate, dividend and volatility assumptions) gives a price of about 4.85% for the lower-strike bought call and 2.22% for the upper-strike sold call, for a net price of 2.63% — extremely close to the $2.60 in the text. In fact if I mechanically add up the price of the Treasury bill ($97.42) and the options ($2.63), I get a value for this product of $100.05, so you’re actually doing a bit better with Innovator, before fees, than if you, uh, got me to manufacture this product.

[7]

This is not tax advice, and my dumb product doesn’t even exist!

[8]

Again, this is a six-month product. So the six-month T-bill pays about 5.3% annualized, but that means about 2.66% for six months.