The exchange-traded fund category, which offers eye-catching coupons, is generating buzz among income-seekers, but investors looking to dabble in these products need to be prepared to do their homework. Introducing autocallable ETFs that aim to bring strategies typically reserved for institutional investors to retail investors. These funds can advertise weighted average coupons of 10% or more, but the mechanics behind these interest rates are complex. “Yield is definitely one of the biggest draws for these products,” said Morningstar Manager Research Analyst Zachary Evens. “We are seeing more interest in the derivative income category because it allows investors to earn such tantalizing yields that have historically not been achievable through traditional asset classes or other more widely available products.”Morningstar’s derivative income category includes 260 funds and $182.77 billion in assets, including the JPMorgan Equity Premium Income ETF (JEPI) This includes covered call strategies such as Autocallables is a subsector of this cohort, accounting for 19 ETFs with total assets of $2.25 billion, Evens said. The Calamos Autocall Income ETF (CAIE) is the largest of these, with assets approaching $1 billion and celebrating its first anniversary in the market. The FT Best Ladder Autocall Barrier & Income ETF (ACYN) is a distant second with $615 million in assets, according to Morningstar. Auto-callable ETFs come in a chassis that is familiar to retail investors, but their structure can be confusing to beginners. “I cannot stress enough how complex these products are and how unfamiliar traditional ETF investors may be to the concept of these products,” Evens added. Boutique Income Strategies These ETFs aim to bring strategies traditionally reserved for institutional investors to individual investors. Banks issue automatically callable yield notes. It is issued over a fixed period of time, uses embedded options, and is tied to the performance of the underlying index or asset. The bond pays a coupon if a set of conditions are met, such as the index or asset remaining above a specified level. These bonds tend to mature in five years and can be called by the issuer after one year if the index is at or above the initial level. The bond also offers some downside protection. This means that you will receive a coupon payment if the underlying index does not fall below a certain percentage called the barrier. Auto-callable ETFs use a portfolio of these yield bonds, making them accessible to individual investors. Investors may be attracted to the prospect of high yields, but income is not guaranteed. In some circumstances, the coupon may not be paid on the note or the principal amount may be reduced. This is the case if the underlying asset experiences a sharp and prolonged decline and falls below the negative barrier. Although this description describes how autocallable functions work in general, investors entering this space should familiarize themselves with how the Fund works. “Each one is a little different, so investors need to understand where those different levels are within the ETF to fully understand what the risks are,” Evens said. To add a new element of complexity, some autocallable ETFs follow a single stock, he added. Where does it fit? Investors drawn to these funds may think they play different roles within their portfolios. “There may be a reasonable use case for someone who has a large unrealized gain position, wants structural downside exposure, and doesn’t rely on real profit distributions,” said Jeff Judge, a certified financial planner at Chesapeake Financial Planners in Forest Hill, Maryland. He said his client base is pre-retirees and high-income earners looking for yield, and autocallable ETFs have come across his desk multiple times in recent months. These services usually require a lot of education from investors. “When people hear ‘yield,’ they always think of ‘bonds,’ but this is not the case,” the judge said, noting that investors could overlook the risk of principal loss in extreme economic downturns. “It’s not income in the traditional sense.” Investors and their advisors need to model how ETFs will react in different scenarios, and they also need to think about what problems they hope to solve in their portfolios by adding these funds, he said. Rethinking asset allocation and risk appetite may be at the heart of the problem investors are trying to grapple with. Fees are also a consideration. Auto-billing ETFs on the market have an average expense ratio of 0.88%, according to Morningstar. As always, higher costs can hurt your portfolio’s returns. “This is a new optional product, so please do your research,” the judge said. “The most important thing is to know what you own. If you don’t understand, don’t buy.”
