The Dynamics of Defined Outcome Exchange Traded Funds

Abstract

Defined outcome Exchange Traded-Funds (ETFs) are investment vehicles that use complex options-based strategies to produce a defined outcome for investors over a predefined period. Buffers and caps are created with options to structure an attractive payoff attained only at the end of an outcome period. We analyze the performance of these new derivatives-based products that are affected by time-dependent nonlinearities in options. Using both options theory and path-dependent simulations, we first show that defined outcome ETFs produce attractive risk-adjusted returns relative to benchmarks when purchased at rebalancing across different market environments. Second, we illustrate the need for risk management late in the outcome period due to changes in option-related risk as the defined outcome period approaches expiration.

Keywords: defined outcome ETF, buffered ETF, portfolio performance, derivative strategies

JEL Classification: G11