SPY - How To Capture Stock Upside With Zero Downside Without The TJUL ETF

2023-08-14 15:37:28 ET

Summary

• The recently launched ETF with ticker "TJUL" offers the upside of stocks with protection on the initial amount invested.
• This is basically what "principal protected notes" offered by banks have long done, and is now possible again thanks to higher interest rates.
• In this article, I show you why you don't need ETFs like TJUL, and instead would be better off creating your own protected payoffs trading options directly.

Having the upside of stocks without the downside risk of ending up with less than the initial amount invested sounds like one of those "too good to be true" wishes of many savers and investors. Earlier in my career, I worked at a bank where we packaged exactly this promise in products known as " principal protected notes ". These were basically bonds, where 100% of the principal is promised to be paid back at maturity, but rather than paying a fixed rate of interest, these bonds would pay more if the linked stock index went up a lot, and as little as zero interest if the stock index went down over the term of the bond. These products had relatively high fees, opaque pricing, poor liquidity, and terrible tax treatment in taxable accounts, so part of my mission since leaving banking has been to provide better investment clarity and solutions than what banks offered and continue to offer. That is why I was surprised to hear an episode of the "Trillions" podcast highlight an ETF that basically packages what a 2-year principal protected note would do: the Innovator Equity Defined Protection ETF July 2025 series ( TJUL ). In this article, I am to take apart what is in this ETF, why I don't believe this strategy should be done in an ETF, and how you can create defined protection strategies like this yourself using options without the costs and limitations of the ETF.

How This Defined Protection ETF Works

The TJUL ETF is just one of the latest of a long series of Innovator ETFs with defined outcomes based on the value of an index or price of an ETF on a specific future date, often one to two years out from the launch date. In my view, their website actually makes understanding the relative upside versus downside of each strategy more difficult and less clear than just looking at the strike levels and expiration dates of the options each ETF holds. Hopefully by the end of this article, you will agree it is clearer to just put these options together yourself rather than bother with any of these ETFs. Before July 2023, all of these Innovator ETFs provided a buffer against market downside, and what makes TJUL new is that it is the first equity-linked ETF I am aware of that promises zero downside if held until July 2025. As mentioned in the podcast linked above, TJUL is probably the first ETF where the SEC allowed the use of the word "Protection" in the name of the ETF.

Very simply, TJUL promises the following outcomes based on where the SPDR S&P 500 ETF ( SPY ) closes on 30 June 2025:

1. If SPY is below 450.84/share on that date, regardless of how much below, TJUL should be worth its IPO price of around $25/share, or
2. If SPY is above 525.81/share on that date, regardless by how much, TJUL should be worth around $29.15/share, a 16.62% total return or around 8% per year, or
3. If SPY finishes between 450.84 and 525.81 on that date, TJUL's value will be proportionately between $25 and $29.15 accordingly.

Since SPY has fallen a little bit since launch, buyers of TJUL at its current price of around $24.75, or NAV of $24.70, may see the benefit of getting even a little bit more than 100% of their investment protected if they hold this ETF for a little less than two years.

The reason this ETF launched now and not anytime over the past decade should be obvious: high enough interest rates. With 2-year note yields ( US2Y ) at 4.8%, it makes sense that I could take two years worth of that interest and use it to buy call spreads on SPY that should double that interest if SPY goes up, or at worst lose that interest if SPY goes down. That is what makes it possible to offer 16.62% upside with "zero" downside: the real downside is giving up two years' worth of interest when interest rates are as high as they are.

When we look at the holdings of TJUL, we see that Innovator is not creating this payoff with a bond and a call spread, but rather by using a very deep in the money call spread, protected by buying an at-the-money put. Specifically, TJUL's current positions, according to its website, are an equal number of the following options on SPY, all expiring on June 30, 2025:

1. Long 8.12 strike calls
2. Short 525.81 strike calls, and
3. Long 450.84 strike puts

Technically, the 8.12 strike of the lower call may mean there is some risk of TJUL being worth less than $25/share if SPY were to fall to, say, $1-$2/share by June 2025. My understanding is that those 8.12 points (1.8% of the 450.84 protected price) is mostly there to cover the expense ratio of the ETF, so should be considered a sunk cost at any rate. Walking through the different possible outcomes of this option strategy should make clear how this ETF guarantees its outcomes:

1. If SPY finishes below 450.84, the put will guarantee that the fund will have the same value as if SPY were at exactly 450.84, or
2. If SPY finishes above 525.81, the fund will need to pay to the exchange the value of the call option, which makes the value of the whole option position the same as if SPY finished at exactly 525.81, or
3. If SPY finishes between these two values, neither the 450.84 put nor the 525.81 call would be exercised, and so the fund would receive the full value of the 8.12 strike call.

Why This ETF Shouldn't Exist

My understanding is that many investment advisors are very different than I am, and might prefer the convenience of a packaged product like TJUL over having to trade options directly. From that perspective, it may make sense to have one ETF that can be bought with a single trade that you know will either return 16.62%, or 0%, or somewhere in between, if you bought it at IPO and hold it until exactly the start of July 2025. I think all those "ifs", and trying to track them from an account statement to the Innovator website, is actually far more confusing than simply trading the options directly, which gives the trader greater control, flexibility, and transparency, not to mention saving the high 0.79%/year expense ratio of this fund. In other words, the single biggest reason I believe this fund is useless is that it would be much easier to see the expiration dates and strike prices of the options you are exposed to right on your account statement , rather than having to look them up separately from an ETF ticker.

How To Create These Protected Payoffs Yourself

Since TJUL simply buys and holds three simple option positions until maturity over a two-year period, it is very easy for any investor with options trading permissions to create very similar payoffs directly as desired. Like many Innovator ETFs, TJUL uses FLEX options since they want the ability to define strike prices and expiry dates to match specific terms they want to offer on their ETFs, but most human investors should be fine with the menu of standard listed options. Looking at the listed options of SPY , which are very liquid out to two years, we see that there are options expiring on June 20, 2025, not June 30, and that strikes are round numbers like 450 and 525, but these are more cosmetic than significant. With these options, I will now suggest two ways you can reconstruct a payoff very similar to TJUL with lower cost and simpler transparency:

Method 1: Buy bonds, spend interest on call spreads

As mentioned earlier, the economics of principal protected stock exposure mostly comes down to exchanging a fixed interest income for an option on the upside of a stock, stock index, or ETF. With US2Y currently just above 4.8%, that means you should be able to buy a $100,000 2-year treasury STRIPS , which will guarantee you receive back $100,000 on July 15, 2025, for around $91,000 today. With the $9,000 up-front "discount" on this principal guarantee, we can then look at buying 450-525 call spreads on SPY expiring on June 20, 2025, which I am currently seeing at around $39 per SPY share. That means with this $9,000 we can buy two call spreads, covering 200 shares of SPY or around $90,000 of notional value, and still have $1,200 leftover to spend on other options or to provide an added reserve. These numbers may highlight one convenience advantage of TJUL someone like me would easily overlook: you can invest $25 into one shares of TJUL and get full exposure on the whole $25, without having to worry about round lots of SPY options, but of course that's because I don't invest in $25 lots.

I would most likely use this bonds + call spread method for a tax-sheltered retirement account, or for the account of a non-US taxpayer, especially as many foreign investors are not subject to US withholding taxes or estate taxes on US bonds . For US taxable accounts, this approach is not ideal as the discount from the US treasury STRIPS would be taxed at ordinary income rates as original issue discount (OID) at the end of each year, so for those accounts, I might either use tax-exempt municipal bonds, or the following "married put" strategy.

Method 2: Buy SPY with "married put", sell covered call

A second way of getting a very similar payoff profile with better tax treatment is US taxable accounts is by investing directly into shares of SPY, and on the same day buying a 450 strike put expiring on 20 June 2025. Buying the put on the same day as buying SPY makes the put a " married put ", and so allows the combination of SPY and its put to be taxed together at long-term capital gains rates in 2025 or later. This put currently costs around $33/share and would be partly financed by selling the 525 strike call, currently at a premium of around $19.50/share, and the rest from the dividend received on the SPY shares, which was $6.52/share over the past 12 months . This of course does leave taxable investors subject to the tax on that dividend, so this would have to be evaluated against the cost of buying a deep-in-the-money call on SPY instead of SPY shares, like TJUL does, for an investor very concerned about that tax.

Conclusion

The main points I hoped to illustrate with these two examples are how defining a specific protected payoff from SPY exposure can be done very easily by investors using options directly rather than through a fund like TJUL, and just as importantly, how trading these options directly allows you more flexibility. If you want your payout period to end in January or March of 2025 instead of June, you can use options expiring in those months. If you want to be more aggressive or conservative, you can choose different strike prices of your options, rather than being stuck with the ones chosen by TJUL. Perhaps most important to me, I don't really like the S&P 500, so I prefer to run option strategies like this on other ETFs tracking small caps, or foreign stocks. Innovator does have some other ETFs based on broad small caps, e.g. ( KJUL ) based on ( IWM ), international developed markets, e.g. ( IJUL ) based on ( EFA ), and emerging markets, e.g. ( EJUL ) based on ( EEM ), but again, it is easier for me to put together my own EEM option strategy rather than hope I like the strike prices EJUL chose for next July.

Options, and even bonds, are sometimes portrayed as far more complicated and difficult than they actually are, but they both have one important feature that makes them very useful for investors with defined time horizons: fixed expiration/maturity dates. While there have been a few other series of ETFs, namely BulletShares and iBonds , the ETF wrapper so far seems to have done more to obscure details like maturity dates and coupon rates than make them easier to see. I truly believe there is no substitute for good investor education, and here I hope I've made the case clear for why we should all get better educated on how to trade options, and bonds, rather than accept the high cost and low flexibility of a fund like TJUL.

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