How Innovator's "Managed Floor" ETFs Can Fit Into a 40/30/30 Portfolio

The limitations of the 60/40 portfolio

The 60/40 portfolio, combining 60% stocks and 40% bonds, has been a foundation of investment strategy, lauded for its simplicity and effectiveness. This balance is designed to sit near the "efficient frontier," which is the ideal balance of maximum return for a given level of risk.

Historically, this mix leveraged the often-low correlation between stocks and bonds—stocks provide growth potential while bonds typically offer safety and income, balancing out volatility during stock market downturns.

However, the traditional 60/40 strategy encountered significant challenges in 2022. As interest rates rose sharply to combat high inflation, the relationship between stocks and bonds shifted.

Bonds, typically seen as safe havens during stock market turmoil, began moving in tandem with stocks due to their sensitivity to interest rates, effectively increasing the portfolio's risk without the expected offsetting stability.

The result was a dramatic -20.83% drawdown for the classic 60/40 blend, surpassing losses seen during the 1987 Black Monday crash and the initial COVID-19 market reaction, though still less severe than the 2008 financial crisis or the dot-com bubble burst.

To fortify against such scenarios, diversifying beyond stocks and bonds to include assets like commodities or real estate might help. However, these alternatives also depend on maintaining historical correlations, which may not always hold, suggesting the need for even more innovative diversification strategies.

Options to the rescue

The appeal of using options as a protective strategy lies in their ability to provide predictable outcomes, unlike traditional asset classes that rely on historical correlations for risk management.

This method introduces a mathematical certainty to potential losses and gains, setting explicit boundaries on portfolio performance regardless of market direction.

Enter Innovator's trio of "Managed Floor" ETFs, each designed to incorporate options to safeguard against steep declines while maintaining significant upside potential:

1. Innovator Equity Managed Floor ETF
   SFLR
   +0.47%
2. Innovator Nasdaq-100 Managed Floor ETF
   QFLR
   +0.89%
3. Innovator U.S. Small-Cap Managed Floor ETF
   RFLR
   +0.3%

Each fund is based on a different reference asset—large-caps for SFLR, the Nasdaq-100 for QFLR, and small-caps for RFLR, with all charging a uniform expense ratio of 0.89%.

To shield investors from downturns, these ETFs employ a strategy of purchasing put options that are 10% out of the money, refreshed quarterly. To offset the cost of these puts, the funds also sell bi-weekly laddered call options.

This systematic approach aims to limit maximum losses to a range of 7-15% across the ETFs while still allowing for 70-80% upside capture relative to their respective indices.

This method results in a 'convex payoff profile'—a structured approach that benefits from both sharp market increases and decreases, offering crisis protection and the potential for upside.

The 40/30/30 Portfolio

Instead of sticking to the traditional 60/40 equity and bond split, the "40/30/30" portfolio presents a more nuanced approach to modern investing challenges, particularly in volatile market environments. Here's how it breaks down:

• 40% Equity Sleeve: This segment can blend low-cost passive index funds with select active or factor-based strategies. The goal here is to capture broad market returns while also taking advantage of potential alpha from more targeted investment approaches.
• 30% Fixed Income: This portion can still utilize traditional aggregate bond index funds for stability, but there's room to include actively managed fixed income strategies. Active bond management might be particularly useful in navigating the complexities of changing interest rates and credit landscapes.
• 30% Alternatives Sleeve: Traditionally, alternatives might include assets like commodities or real estate, but this revised portfolio suggests a strategic use of defined outcome ETFs. Products like Innovator's Managed Floor ETFs can be employed here to hedge against downside risks while still participating in market upsides through structured options strategies.

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.