Buffered Strategies: How They Work & When to Use Them

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  • 55 mins 14 secs
Buffered strategies and other Defined Outcome approaches are among the fastest growing areas of the ETF/Mutual Fund and annuity markets and continue to be a significant issuance of the major banks. These products will continue to grow and catch the attention of advisors, agents, and clients alike. This presentation explores how these strategies work, the most appropriate ways to use them, and how they should be presented to clients. 


Catalyst Funds

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Larry Milder: Hi, this is Larry Milder, national sales manager for Catalyst Funds. Welcome to today's continuing education presentation, Buffered Strategies: What They Are, How They Work, and When to Use Them. At Catalyst, we strive to provide innovative strategies to support financial advisors and their clients in meeting investment challenges of an ever-changing global market environment. The foundation of our investment philosophy is built on three key strategies, alternative hedge strategies, income-oriented strategies, and equity-oriented strategies.

Today's speakers are Joe Halpern from Exceed Investments and Rick Burdick from Catalyst Funds. Joe is the founding partner of Exceed Investments LLC and portfolio manager of Catalyst Buffered Shield Fund, ticker SHIIX. Mr. Halpern has structured, priced, and traded billions of dollars in structured products, exotic derivatives, and listed options. Additionally, he has managed trading groups, supervised risk management and participated in executive level firm wide strategic initiatives for several leading financial institutions. In 2012, Mr. Halpern founded Exceed Holdings LLC, an investment holding company focused on developing next generation structured investments. Joe has a BS in finance and accounting from New York University Stern School of Business. In 2017, Joe partnered with Catalyst Funds to launch the Catalyst Buffered Shield Fund, a defined outcome strategy mutual fund. 

During the presentation, Joe will be joined by Rick Burdick. Rick is a regional vice-president for Catalyst and Rational Funds in Central and North Florida. Rick has been in the investment industry since 1991. He has worked with annuities, alternatives, and various risk protection strategies for a majority of his career. Rick has conducted hundreds of training seminars on risk protection concepts for both financial advisors and individuals’ investors nationwide. Mr. Burdick received a BS in finance from Bentley University. We are pleased to bring you an experienced alternative manager like Joe today to discuss buffered strategies and other defined outcome approaches, which are among the fastest growing areas of the ETF, mutual fund universe. Now let's turn things over to Joe.

Joe Halpern: Thank you, Larry. In the late 1980s, most likely in an office down on Wall Street, a financial engineer came up with the great idea of combining or embedding a package of options with a zero-coupon bond with a fixed income security, and an industry was born. I believe that first trade was an $8 million trade, and now it's a two plus trillion-dollar global industry. A structured product is essentially a bank issued note, so bank issued debt, with an option or an option strategy sitting on top of that.

Shortly thereafter, shortly after that first trade, it really took off, especially in Europe. In the mid 1990s in Europe, you could go to a post office in Germany and buy a structured note. They have exchanges dedicated to structured notes in Europe. It's a larger industry in Europe if you could believe that. And very shortly after that first note was issued, the insurance industry took note as well. And in 1995, they created, the insurance industry created the first indexed annuity. An indexed annuity is essentially a principal protected structured note, so the insurance company issues the bond, and then embeds on top of it, options to create that exposure.

And for those not as familiar with the fixed indexed annuity, it's principal is protected at maturity. And typically, it's a one year reset of an S and P 500 exposure. So, you might get up to, let's say a 3% or 4% annual return if the market returns, or the S and P 500 returns about that. And then the next real material innovation, at least from an issuer standpoint, there were a lot of innovations in what sort of strategies came out in the market, was in 2013 when AXA issued the first buffered annuity. 

And what this did was take another step from an innovation standpoint, another step in the insurance world, in providing a different risk reward exposure, where now the downside was buffered, so it wasn't fully protected, but you protected on some amount, let's say the first 10% down, for increased upside. And then finally, and again, based on just global demand by clients, what has become a huge complex, the 40 Act space really looked at this and said, "Hey, we could do a great job too, and we could marry the benefits of structured notes with the benefits of a 40 Act." And 40 Acts are ETFs and mutual funds and the like.

And what's happened over the last few years and is really increasing, and that's why this is really a timely CE class, is that mutual fund issuers and ETF issuers are looking at this product and saying, "Hey, we could really bring a lot of innovation." And we'll talk about that in this presentation. 

So, flash forward to 2020, and you could see here on the top that sales are close to $150 billion in the US alone. The bank issued structured notes, which are those issued by the likes of Morgan Stanley, and Citi, and Goldman and Barclays, the who's who of really the investment banks out there. In 2020, estimated sales were $72 billion, which is a 30% expansion from 2019. Globally, that number I believe is close to $200 billions of annual sales by the major banks. Fixed indexed annuities in 2020 actually had a decline of 25%, but it's still a dramatic amount of the annuity complex at $55 billion a year. The whole annuity complex had a decline of I believe 10% in 2020, so fixed indexed annuities got hit a little bit hard there.

But on the other side, buffered annuities were really a bright star for the annuity complex at $22 billion. This is a product that first was introduced in 2013, so within eight years, they got up to a $22 billion annual sales. That's pretty impressive. And some of the buffered ... We mentioned AXA before as a buffered annuity issuer, Brighthouse, Allianz, Lincoln are some of the other major issuers of buffered annuities. Athena, AIG, and Allianz are some of the other FIA, the fixed income indexed annuity issuers. 

And then the 40 Act products, which really started a few years ago, they had close to $2 billion of sales in 2020. Obviously, pales in comparison to the other products here, which came out well earlier. But as you can see, there was 100% growth in 2020 of this product. And we believe over the next decade, these products that the 40 Act encompassing ETFs and mutual funds will really mushroom and become a larger and larger portion. It will definitely have the strongest growth over the next decade. Some of the issuers there are Catalyst Funds, Innovator, and First Trust. 

So why are these products so popular? And the answer really is that investors need stability in a volatile world. Right? If you look at the last three years on the bottom, and this is from basically beginning of 2018 to 2020, you could see how much volatility there was in the market. Right? If you look at the beginning of 2018, while we say it's a flat volatile market, in Q one, there was a 10% drop. And you can see it right there in the little orange line. Right in the beginning, there's a 10% drop before the market really topped out for 2018, around September, at maybe an 8% or 9% return for the year. It might've even been less than that. And then all of a sudden, we had a 20% drop. And it was pretty aggressive, October dropped about 8%, 9%, and November, you had a pop back. And then December was close to 15% drop that really right around Christmas, you got to the bottom. And that was a function of trade wars with China exacerbated by Powell and the government being at odds over rates, so Powell was increasing rates while we were going through a really turbulent time.

And once that got aligned, meaning that once the feds started easing instead of raising rates, you're really off to a great rally, which encompassed all of 2019. But even in 2019, which was a 30% return, annual return for that year, you did have a 10%, 12% drop in the summer there, so it's still volatile. And then COVID occurred, and we all know what happened there. You had a 35% drop from top to bottom before getting a pop as fed eased. So really volatile over three years. If we took this out to five years, 10 years, 20 years, you have the same story. And ultimately, investors can't handle that. They can't handle the full swings of the market. You have someone who's worked really, really hard, who's coming up to retirement, puts $100,000 in. They can't get that call from their advisor that your $100,000 that you worked so hard over the last decade to create is now worth 70.

So, they demand some level of risk mitigation, and they're willing to trade off on returns. And buffered strategies really provide what the investors want. If you look at the graph on the bottom now, instead of having a 20% drop during that fed China event, you may have a 5% drop. And instead of a 35% drop when COVID occurred, you may have a 9% drop. And yeah, you give up a little bit on the upside. Right? Instead of maybe a 30% or 40% pop, you might get a 10% or 20% pop or participation on the upside. But what this allows people to do, or investors to do, is to handle the full swings of the market. They could stay in there.

And what buffers do so well, or buffered strategies do so well, is they allow that client or the advisor on behalf of the client to decide what the risk reward should be. They could decide, okay, this client could take a little bit more risk. I'll have a smaller buffer. Or maybe that client can't really afford to take much risk. I'll have with wider buffer and I'll still participate. And what's really interesting here is that buffers are very defined. Right? And we'll get into kind of what underlies these products. But they're really contractual by nature, and what that means is it really takes away the ambiguity of the product.

So, when you look at other products that may provide risk mitigation, like let's say a tactical strategy, which seeks to just simply get out of the way when the market goes down, you don't really have that definition of: Well, how's it going to do it? And how much will it be down if the market's down 20%? A buffer really allows you to do the math, where if you, let's say, have a 10% buffer and the market's down 20%, you know that you are going to protect on that first 10%. So, it really provides stability not only by risk mitigating, but by also providing that level of definition of how it's going to risk mitigate.

So, what exactly is a buffered note? We're going to use an example throughout the rest of this CE, where we define the buffered note as a one-year product based on the S and P 500, and roughly 20% to 25% of everything issued in the complex is based on the S and P 500, with a 10% buffer level. And now we'll explain exactly what that is. So, if you look at this chart, the orange area, which is called the buffered zone, is as we mentioned, a 10% buffer. It protects on the first 10% down. So, if the S and P drops, let's say 5%, at maturity, and this is a one-year product, so you buy it today, and in one year from now, if the market is down 5%, at maturity you will take no loss. 

So, if you put $100,000 into the strategy, and one year later, the market is down 5%, if you are invested in the S and P 500, you would now have $95,000. But in a buffered note, you would still receive back $100,000. And because this buffered note as we defined it is a 10% buffer, the same would be true if the S and P was down 10%. Someone who bought the S and P would lose 10%. They'd have 90,000. An investor in a buffered note would have 100,000. And then thereafter, it's really a one-to-one relationship, meaning if the S and P was down 15%, you would actually lose 5%. So, your $100,000 in the beginning of the year would turn into $95,000 with the market down 15%.

And meanwhile, on the other side, on the upside, excuse me, it's really the participation zone. And this is highlighted in light blue. So, if the market was up 5%, the S and P, someone who owned the S and P would receive 5%. They'd make $105,000. And the buffered note, you'd also get $105,000. But meanwhile, you're capped or limited on your upside at 9.5%, which by the way, is a very nice return for a conservative investor. And if the S and P was up 15%, well, now someone in the S and P would have $115,000. And someone in this note would have $109,500. So again, it's a reasonable exchange, basically saying, "Hey, protect me on the first 10, and I'll limit my upside in exchange for it." And that's what a buffered note does so well. And again, this is really defined, unlike a lot of other strategies, where you're hoping that you could achieve some level of characteristic like this.

So, let's examine how this works in an up market. So here, let's say the S and P return was 12% over that one-year period. And as you could see from the orange line, it goes upward. Right? And then the buffered target return in our example would be up 9.5%, and that's that gray dotted line. And you can see it'll go right up to that green dotted line, which illustrates the cap on the upside. And another item to take away from this slide is that it's not binary, meaning that if the S and P 500 popped 10% within the first month of holding the strategy, the strategy itself, the buffered return, would not be up 10%. It might be up 4% or 5%. And that's illustrated as you see in the gray line not just hugging the orange line, and then kind of making a right hand turn at the green dotted line. It really will participate on the upside until the cap, at which point, they'll stop.

And so, this will provide a smoother ride through the market. Obviously, everybody wants to capture the whole upside. But as we'll see in the next slide, in conjunction with the downside, this is a really nice return, given the mitigation on the downside. So how it works on the downside is, let's say the S and P return is down 15% over that one-year period, which is illustrated by the orange line. It's actually gone through the green dotted line. Well, at maturity, the buffered strategy, again, using our example with a 10% buffer, would only go down 5%, so you have this great out performance.

Again, it's not binary, so if the market dropped 10% very quickly, you wouldn't actually have full 10% protection. You might have 5% worth of protection on that day. But at maturity, it is contractual by nature. It's defined, and you will capture that 10%. And this down-market exposure, in conjunction with the upmarket exposure that we just went through on the slide before, provides a much smoother ride for the client. It's going to be much less volatile. The more the market is volatile, we tend to have lower and lower volatility levels, given where the market is. And it's ultimately what the client wants. Right? The client wants a risk reward where there isn't ambiguity in terms of what kind of mitigation there is on the downside. And there isn't a lot of ambiguity in terms of what upside you can get. So, it really does create this nice perfect combination, where the client understands their participation levels, and also understands their hedge levels. 

So, what's really interesting here is that all the strategies, and we talked about a $2 trillion plus market across multiple complexes, across bank issued notes, across insurance products, and now the 40 Act guys are getting into it through mutual funds and ETFs. The strategy is all the same. The sausage is made the same way throughout all the complexes. They're all option based, and they all have an element of fixed income of some level of bond embedded beneath it. And that makes it really interesting because ultimately what occurs is you have the same exact strategy throughout all three. Right? They're all made the same way by the financial engineers in all these different complexes. But ultimately, depending on what wrapper and what structure you issue it in, they all have different qualities that may make it better to do it one way versus another based on the investor and based on what you're trying to achieve.

So, given that the sausage is made the same way in every single structure, let's first look at how the strategy's created. And then we'll come back and look at what the benefits and detriments are within each structure. So, let's take a step behind the scenes. So, it's ultimately made by putting together or combining a bond. And we illustrate that by that gray first circle, embedded with an option strategy. And the option strategy has two components. It has a downside hedge, illustrated by that light blue circle, and then an upside participation level, which is that dark gray circle, and all three together combined create a buffered strategy.

So, if someone was to invest $100,000, let's say in that example that we've been using throughout, the one-year S and P 500 based 10% buffer, 9.5% cap strategy, they may put in that $100,000, let's say we give it to a bank. Okay, it's a bank issued note in our example. $98,400 would go into the bond. And the way that works is we're saying there's a 1.6% yield. These are typically a zero-coupon bond, even though you could obviously take a regular bond and strip it of its coupons and create a zero coupon. Ultimately, the math always works the same. And $98,400 goes towards the bond, where, by the way, we're ignoring fees in the example.

And then the next part is that in a buffered note, you're actually selling the put. And it seems counterintuitive, we'll get into it and explain why. But you're selling the put, when you sell the put, you're actually taking in premium. And in this example, the premium is $2800. So, you have the $1600, which is $100,000 less than $98,400 spent on the bond, plus $2800 that you received in premium from selling the put. And that leaves $4400 to buy a call spread. And what a call spread is, you'd buy the call, which is at the money, so you'd buy the call at the level where the S and P 500 is now. And for those not that familiar with what a call is, a call is an option which gives you the right, not the obligation, but the right to buy an underlying security, in this case, the S and P 500, at a specific strike level.

And the strike level in this example would be where the market is trading now. So, if the S and P 500 are trading at 3000, the call gives you the right at some future point in time, let's say one year from now, to buy the market at 3000. And if the S and P 500 goes up 10% to $3300, your option's now worth $300. You increased it by 10%. And meanwhile, if the market went down to 2000, you don't need to buy it at 3000. You could just give it away for zero. So, you pay a premium for that. And then on the upside, from a call spread, you're actually selling the call. And we'll look at how this works in conjunction with each other, but needless to say, you're selling that right to someone else to buy the stock or the S and P 500 at some level above. And this costs 4400. And all together, it creates that $100,000 investment. 

So again, the bond, which is that silver circle, plus the downside hedge, plus the upside participation, creates the buffered strategy. So, looking at that downside hedge, and as we discussed, this part was a little bit more counterintuitive because you think to provide some risk mitigation, you would actually buy a downside put for insurance purposes. Here, we're selling one. The reason that we do that is that there's no actual exposure between where the market is now and then down 10% in a buffered strategy. Right? And we'll look at the upside and the downside. Now we're looking at the downside. Right?

If you buy the S and P 500, and the market goes down 1%, you do have exposure. You'd lose 1%. $100,000 investment would turn into $99,000. By selling a put 10% below the market, which means you're selling the right to someone else to sell the market 10% below, you don't have exposure between zero and minus 10%. And so, if the S and P 500 over that one-year period goes down 8%, you actually don't lose anything. That put will expire worthless because it's only worth something if the S and P 500 is down 12%. So that's why you're actually selling a put as opposed to buying a put in a buffered strategy. 

Meanwhile, on the upside, you start having exposure right at where the S and P level is and above. Right? So, if the market goes down 1% when you're long and at the money call, when you're long the call, at the level at the S and P 500 was before, you don't actually lose anything. Right? The call spread will go out at zero, but you don't have a negative. So, if the market goes down 5%, you don't lose anything on that upside call spread. The call spread just is worth zero. Meanwhile, if the S and P 500 is up 5%, you will also make 5% because your call spread encompasses, it goes from 100 up to 109.5%. And that's why you're paying a premium. 

In our example, the premium was $4400. Right? And so, this premium is allowing you to capture the upside up the 9.5%. Now above that, let's say the market was up 15%, you have a long call, which would make 15%, but then you provided the right to someone else to buy the market up 9.5%. And so, you give up everything above that. So, there's no exposure above the cap because the two calls set each other off. 

And so now putting that all together and putting those numbers together so we can understand what the return profile looks like in different scenarios, that bonds that we initially bought at $98,400, at maturity, it becomes $100,000. You collect that 1.6% of yield, and $98,400 plus that $1600 of yield on $100,000 face bond creates $100,000. Now we can get into some of the risks. Obviously, in 2008, Lehman Brothers went under, and then you had some issues there. And we'll get into that. But primarily, you're buying these products from JP Morgan, Citi, the majors, the major insurance companies. And within the 40 Acts and the ETF companies, they're also taking those bonds from the majors, so it feels pretty secure, and we feel pretty comfortable saying, "You're going to get back that $100,000 based on the bonds." 

And then that downside hedge, the blue circle, the hedge that's selling the put, well, that initially we collected $2800. If the market is down 15%, you'd lose $5000 on it. You'd lose the difference between down 10 and down 15. And so, in a 15% downward move, you get $100,000 back for the bond. You'd lose $5000 on the hedge. And then the participation level, that call spread, you don't lose anything, so you're flat. So, you see how this works, that buffered note would actually give a 5% negative return, when buying the S and P 500 would result in a down 15% return. If the market was down 5%, that short put would go out worthless, so you'd lose nothing. And the call spread would go out worthless. So again, you'd outperform the S and P 500 by 5% there.

And meanwhile on the upside, if the market was up 5%, you'd make 5% on participation, so that $5000, so you'd do just as well as someone in the S and P. And then if the market was up 15%, excuse me, 15%, well, you have a cap on your returns of 9.5%. So, you'd capture a nice bulk, but again, I believe it's a really nice return, given the risk mitigation on the downside. You capture 9.5% or $9500 when someone in the S and P would capture $15,000.

As mentioned, buffered strategies are packaged into three main product structures. And now we've really gone over how the sausage is made. And now when you take those strategies and you put them in different wrappers or different product types, you have some different qualities and some different characteristics that play out, that provide, that create some benefits and some detriments, depending on what structure you use. And it's really important to understand those, so you really can make the best decision for that client.

So, let's first look at the original product, the bank issued structured note. These were the products that came out in the late 1980s. They had sales of approximately $72 billion in 2020. And the major benefit of these products is the extreme flexibility and customization they provide. You could go to a bank, and you might need a minimum of $500,000, but you can make up anything you come up with, and odds are, the bank will price it. I used to work on a bank desk, and I was engineering these strategies. People would come with the craziest ideas. I mean, you could go and say, "I want to make 10% if the average temperature in New York City over February stays above 20 degrees." Now that's a crazy ask, and it's going to be very hard to price, but it's all math. Believe me. I would've priced a product like that. There wouldn't be a lot of liquidity in it. But ultimately, that's the beauty of the banks.

You could go to the bank and you could ask for anything you like. They do have calendars. You could get onto their calendars. But ultimately, that's the best part. They're also a brand name issuer. If you go to a client and say, "Hey, I have this Goldman Sachs based structured note," the client's probably not going to be, "Who is Goldman Sachs? Or is that okay?" And then finally, there's a standardized approach between all the issuers, so whether you go to Morgan Stanley or Barclays, the language is all the same. Anything you ask one, you could ask the other. And so, it's very easy from a competitive standpoint to see how that person may price something that you request.

On the detriment side, and as we'll see in a lot of strategies in the market, the characteristics are static. They have to be held to maturity. And the reason they really have to be held to maturity is there's a low level of liquidity in these strategies. There's typically a 1% wide market. And because the issuers know that after they issue the product, you're generally only coming back to sell the product, they're going to make it bid side, so they're really going to collect 1% on you. 

And then access can be complicated with high potential minimums. You do have to have clients do paperwork. You do have to figure out how to get there. And some of this is getting eased by some fin techs. And we'll discuss some of the other innovations coming out in the space, but ultimately, that's a third detriment tier. 

Meanwhile, buffered annuities really provide the benefit they provide, and one of the reasons they became so popular so quick is that they're this great sweet spot right between fixed indexed annuities, where you're principal protected, but your upside is really limited, and then variable annuities, where it's not really defined, and some of the programs that the annuity providers provide could be quite costly and quite complex. The issuers, the insurance issuers also are very standardized from a calendar, program and offering standpoint. You could probably get into a structured note twice a week on the S and P 500 at most of these issuers. And then finally, as annuities do, you have great tax benefits, so it's really a good product to put into a non-qualified account.

On the detriment side, these products are not liquid at all. This is really a longer duration purchase. Surrender fees really reduce liquidity. And then on top of that, there's other liquidity constraints within the programs. And then the offerings aren't quite standardized among the issuers, which makes it hard to create an apples-to-apples comparison, let's say between AXA and Brighthouse, as an example. And then longer duration buffers have some increased risk for downside. What I'd say is if you're looking at the five-year, six-year strategies, you really want to use a buffer that's more than 10%. And we really get into this if you go to, I created an under the hood series, which was also educational, even though it's not CE approved at Catalyst Insights.

If you look up under the hood, you could learn more about some of the risks of doing a really longer duration product. You just have to be careful of how you risk mitigate there because you don't really capture, due to the dividends, and I'll leave it at that. And then finally, we have your mutual fund ETF product. And the beauty here, and this is a really quick evolving space because it's so new, is the evergreen offerings. It's the one space where you really do have the ability to really stay in a product. So, they're best positioned within the 40 Act, within the mutual fund and ETF complex to create an evergreen product, which is easier to use within model portfolios.

You also get that daily liquidity at NAV. And it's really easy access, on most platforms, it's points and click to purchase what you need. The detriments are that there's less flexibility. You obviously can't customize anything with a 40 Act. It's not necessarily tax optimized, and for the most part, you're really dealing with shorter duration strategies. 

So, in summary, going over the pros and cons of each of these wrappers, of each of these strategy or structure types, from a liquidity standpoint, the ETF mutual fund complex really wins out. You have daily liquidity at NAV. You have no surrender fee at all to enter or exit, really, to exit the product. From an administration standpoint, you also benefit from the 40 Act in that there's no paperwork really involved. And it's really easy sometimes, and we'll get more into it when we talk about innovation, to implement within a model. So, there's some ETFs out there, which are really point to point, and they do turn over. But you do have to be careful when they turn over, to really understand the new characteristics.

In the mutual fund complex, there's some that optimize, so they really do make it really efficient to be in a model and to really scale up for your clients. And then finally in the client experience side, the bank should structure notes, and the structured annuities will be the best at providing perfect downside definition in that it's truly contractual by nature. ETFs and defined outcomes will give you that definition as well. It'll be a little bit softer, but it is that definition at maturity and given an evergreen for those optimized products, where you always have a really nice level of definition. From counterparty risk, the bank issued structured notes have some, Lehman Brothers is an example, they have a little bit, but I'd say it's pretty low. Structured annuities, even lower because most state regulators have funds to control if there is a bankruptcy.

And then there's really no counterparty risk with the ETF, mutual fund standpoint, just the way it's structured. And then again, and characteristics always relevant. Most strategies in bank issued and structured annuities are defined, so they're really point to point, so the characteristics could change very quickly. And again, some of the optimized programs coming out, the characteristics are actually always relevant. 

So, depending on how you're looking at it, from what context you're looking at it, different strategies work best based on that client need. So, for example, if you're looking for an open-ended strategy, and what I mean by that is that you just want this evergreen, this everlasting risk mitigation, where you could put a client in and say, "Hey, now I have a client that's being risk mitigated using these strategies," mutual funds may be the best. And structured notes are the most targeted, meaning you say, "Over the next two years' horizon, I need 20% protection, and I need this outcome," you could go right to a bank issuer and get that. 

From a liquidity standpoint, again, mutual funds and ETFs will be the most liquid, while the annuities are the least liquid. And then in a tax efficient context, annuities are by far the best because they give you that annuity level of tax efficiency, and mutual funds are probably or definitely the least tax efficient. And so now I'm going to turn it over to Rick Burdick to provide how one should present to clients.

Rick Burdick: Thanks, Joe. I appreciate that. So, in my 25 years of experience, most of my career has been focused around trying to help the clients with protection strategies as they near or enter retirement. And one of the things that I have found to be a common thread is that as clients are approaching retirement, as clients are either accumulating or they're about to go into an income mode, and you just simply ask clients where their sentiment is about their retirement money, and invariably, the number one concern that clients have is they don't want to lose their money.

So, one of the things that these strategies offer is they offer solutions to help clients have that confidence that they're able to invest their money and to know that they're not going to get whipsawed by the market and feel the feel brunt of it, whether you're using the buffered annuities, the structured notes, or the ETFs and mutual funds. These strategies all give clients the comfort of knowing that they can participate in the market on the way up but have some sort of fallback plan and some sort of protection strategy if the markets work against us unfavorably. So, Joe, with that, why don't you walk us through a few real-life examples and the reality of using these in real-time? 

Joe Halpern: So now that we have a bit of a foundation of how these buffered notes work, let's look at some examples using the last year as a proxy. So, this is from February 2019 through 2019, where we really had a great return. 2019 had a 30% return for the S and P 500, followed by what occurred with COVID, so we have a nice volatile kind of frame here to use and look at examples. 

And if you entered at entry point number one, which was February and March 2019, and held it through, you really got stuck with COVID. And what's really interesting is that given a point-to-point solution, the S and P return over a one-year period starting in the Feb, March 2019 period and ending in Feb, March 2020, ranged from negative 20% to up 25%. That is a dramatic range, and it underlines how much volatility there can be in the market. A buffered note range would've been minus 10% to plus 9.5%. And the reason we point that out is it obviously mitigated on the downside, but it really puts a lot of pressure in when you enter the strategy. And it's just really important to understand that when you do a point to point, that's some of the risk you take. 

Yes, you get that real high level of definition at the end of the term. Right? But being off by two weeks of entry may hurt that. So, you may want to think about strategies to really diversify your entry, exit. If you're using structured notes, you might go to the bank every two, three months and do another portion of it, and edge yourself in. Same with the ETFs, and then there are some mutual funds that actually do this. And some ETFs, by the way, which do that, which mitigate for you by going in over time. So, unless you have a very static understanding of, hey, I only need this for this timeframe, it's a thought to have.

Meanwhile, if you look at entry point number two, over that one-year period, there was a range for the S and P of ... And that's starting in May 2019, the S and P really returned between minus 5% and up 5%. And that's an example of where the buffered really shined because you didn't lose any money in any instance. You made it. And then you really would capture, especially if you have a cap product, you'd capture most, if not the full amount of the S and P.

And now what's really interesting is points number three and number four. They haven't quite played out yet. They're starting to play out now. Point number three is right around January, so I guess right now, you're starting to see that play out, and you'd probably do pretty well. And then point number four at the bottom, getting into the bottom, you're also going to do quite well right now. But one item to really point out here is that when entering at point number three, there is very low volatility in the marketplace. And meanwhile, at point number four, there's very high volatility in the marketplace. 

And so, if you're doing a longer-term structure, let's say a five-year strategy, entering at point number three, your cap is going to be much lower than if you entered a five-year strategy at point number four. And the point I'm kind of underlying here is that you do have to be careful between how long or short the duration may be on the strategy when using these longer-term products because of how the volatility generally affects the cap. So, this is really if someone downloads the presentation, this is a good page to review the points that we just went through on the page prior.

So, some of the other items to really watch out for when buying these strategies, and again, I want to reiterate, these are really popular strategies because they do allow that client to have a really defined risk reward exposure and to understand their downside and understand their upside. But as with every single product out there, there are some complexities that make sense to understand. So, one example would be: What's the reaction to a material market move? Right? So, what happens to the value of the strategy if you purchase a buffered note right before a material market drop? If you buy it, and then over the next month, it's down. You buy a one-year strategy, let's use the same example we've been using, if the market drops 10%, well, your strategy is not going to be a zero. It's not binary. You will provide some risk mitigation. But if volatility really pops, like what happened with COVID, that strategy might be down 8%.

And even with that decline, you may think, "It may make sense to pop out of it," but that's where it gets really complex when you have point to point. And again, there's some optimized products out there, which may help you think this through, or use a professional asset manager to think through those iterations.

Another example from reactions to a material market move is: What if the market is materially below the buffer? That's another one where all of a sudden, now you have one to one risk. And so, there's a lot of thought that goes into, "Okay, what do I do now?? Do I sit with it? Or do I try to pop out at that point? We've already gone over some of the risks to longer dated strategies, and that was really highlighted by entering the market in our example .3 or .4 prior. If you're buying a much longer dated strategy, you do want to understand where volatility is, because if it's near lows, you're just not getting paid as much. It might make sense to do a shorter duration strategy, and then pop out to a longer one when an event like COVID occurs. 

And then finally, not capturing the dividend really affects long-term strategies, and that's again one where you may want to look at me under the hood series, which is educational on the Catalyst Insight site. Dealing with secondary markets is another one. We would recommend unless in an optimized strategy to really only get in at issuance. When you think about some of these ETFs, which are great products by Innovator, by First Trust, by some others that are coming in there, I think it's really important to come in at issuance. If you start looking at the characteristics at other points of time, the probabilities underneath change a bit, and it gets really complicated. So, I would be a little skeptical. The characteristics are true, but because the probabilities change so much, you just want to be careful with how you're dealing with it and how you're dealing with secondary purchases.

And then finally, scaling a book of business with buffered notes, it does become a little bit of a headache of: How do you deal with clients coming in at different times? You can't necessarily put them all in the same buffer, and so you really either have to be really buttoned up in your approach and how to deal with multiple different buffered notes, maybe trying to get the timing right, but it becomes really hard to scale your business, and that's where some of the diversified strategies and some of the optimized strategies really may help someone who is a fee only advisor or a RAF advisor, dealing with a stable or a portfolio of clients.

And so, what's next for this space? This is a $2 trillion global complex. There's client demand. We see great growth across the different structures. Right? And so, some of the innovations coming down the pike and some that have come already are like Halo, where you get that fintech approach to the bank strategies, which allows you a little bit more capability of getting access to products and a little bit more capability of getting good education. They're starting to be packaged in new ITs, we'll see how that goes. As the product becomes more and more popular, there's going to be more calendar offerings by all issuers, which is great. It gives more flexibility to the client.

And then finally, and we spoke about it a little, optimization. Optimization, we believe, is the next step forward within space. It's really exciting because as you have more and more RIAs and more and more approaches where you use RAF accounts, fee accounts, it really does allow you to put it into a model in a very efficient manner and taking what is a point to point at maturity product and creating it evergreen. And so, what we'll do here is I'm going to turn it back over to Rick to really discuss in detail how this optimization works.

Rick Burdick: Okay, Joe. Thanks a lot. So how do we maintain our progress? I love this picture because if you think about investing and saving for retirement, it's much like climbing a mountain. And if you were to climb a mountain and you climbed 3000 feet, you'd feel extremely accomplished. But if you suddenly fell 10 feet, you would have a completely different perspective, and you would not feel as accomplished as you did five minutes ago. So, all of the strategies that are in this space have figured out how to capture gains in various mannerisms. 

Typically, the annuities are going to give you an annual step up. Some of them, it might be a few years, might be two or three years. And typically, the notes are either one or two years. One of the things that we're trying to do is help clients walk through their emotions. This is a very real description of what clients are feeling when they go through this investment process. When they start out, everybody is optimistic. And when the markets go up, their emotions go up and correlate with it. They get excited. They're euphoric.

And then we see a decline in their investments, and we see their values might go down with the market turn, and they have some anxiety. They have fear. And when markets really go down, like we saw in March of 2020, then panic sets in. And at the bottom of those markets, most investors are going to feel hopeless, and they don't know what to do. And when the markets then start to recover, they start to feel relieved. And then we go back to the optimistic and excitement cycle. And this is a very real example of what clients are experiencing when their money is going up and down. They don't understand it as well as the financial professional does, and they do get scared. And sometimes that fear leads to poor decisions.

So, what we're trying to do is help them through this process. Optimization can help you preserve gains for investors. This is an example of showing that if we saw the S and P 500 return 14%, and in the buffered targeted return, you captured a lot of that, you captured 11%. You want to make sure that if we see a reversal in the market, that those gains are somewhat protected. So, one of the innovations that we can see today is in the 40 Act space, the 40 Act strategies, where they have a rolling floor that can move along with client gains. So much like a mountain climber that's putting carabiners to protect their progress and prevent them from losing any momentum that they have, the optimization model provides a rolling buffer or a rolling floor that moves along with their gains.

So, this is an example where a client put in 100, and the market went up 14%, and they saw their 100 grow to 110. But along that same line, their floor was moving along with their progress. So, when their original floor was somewhere around 90, as the optimization moved with their value, now their floor at the end of this time period was sitting around 100. So, a client is going to feel a lot better about going through the next market cycle knowing that their progress has been captured. How we see this playing out with various market conditions really depends on what's going on in the world.

When we have a flat market, or we have minimal volatility, clients have a lot more confidence not to worry about what's happening with their investments. But when we see market moves, like for example, we saw a swift market change when we were negotiating with China. But then we saw a rally after that. Clients are going to feel that. And 2019 was a great year for investors to participate in a very lucrative market. But then COVID-19 happened, and March 2020 was nothing short of a panic for a lot of people. And those that stayed the course and had something that helped ease their emotions and kept them invested, well, those people got to experience a very robust rebound. And they ended a very traumatic year for a lot of people, they ended in the positive.

One example of that, and this is a real-life example, is the catalyst buffered strategy. In 2019, again, a very robust year in the markets overall, we see the broad scale markets move upwards of 30%. Well, in the catalyst buffered shield, we saw about a 2/3 capture of that. The buffered shield was up 20%, capturing about 65% of the market gains. In our experience, clients are okay if they don't participate in 100% of the market. They would rather give up some returns to have some protections, rather than be fully invested and have the full downside.

The optimization in the catalyst buffered shield shows how the 2020 market decline was an example of where the protection kicked in. We went through 2019 and we had a lot of gains. And with that, we saw the floor move up and protect those gains going forward. As the market collapsed, and essentially, the market was in almost a free fall for 30 days, the buffered kicked in and was able to mitigate some of that downside and give clients a little bit of a cushion to participate. At that point, clients didn't bail out of the strategy. I've talked to a lot of people that were very uncomfortable in that scenario, and some people went to cash and they missed the recovery. 

The buffered strategy helps keep client’s calmer. It helps keep them confident. And it allows them to stay invested and participate on the swings and capture the upside as well. The goal here with all of these strategies is to give the clients the best of both worlds, to participate in the upswings, but also protect them on the downswings. These optimization strategies, which will go across all the solutions that are out there will eventually evolve and enable clients to participate in these markets, lock in their gains along the way, and feel the carabiner effect like mountain climbers have.

Larry Milder: Thank you, Rick. And thank you, everybody, for your time today. You can learn more about this last strategy that Rick highlighted, the catalyst buffered shield strategy, by going to catalystmf.com. And a little bit more about the further education of under the hood on Catalyst Insights, which is slide 35 of this presentation. I hope you all learnt a lot and look forward to everybody using these strategies. Thank you. 

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