Diversified Alpha is Better Than Constrained Beta 

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Investors are always looking for a way to reduce their risk while preserving upside. That’s why defined outcome funds are one of the fastest growing ETF segments with 10bln now managed by the industry leader in just a few years. These funds are designed to cap downside (say -10%) in exchange for capped upside (say +15%) at a cost of ~80bps annually in fees.

While defined outcome managers pitch constrained beta as a way to reduce risk, there is only one consistent free lunch in investing: diversification. Defined outcome funds simply transform the pattern of single asset returns and with it incurring substantial fees and performance drag as capping big upside years matters more than limiting downside. While it might work out in any given year, over time investors are much better off using diversified active management to reduce their risk relative to an index.

The chart below compares the returns of the S&P 500, our Composite HF Index and a simulated SPY defined outcome fund with a -10% downside cap over the last 20+ years (please see the methodology note at the end of the piece for more information). Returns are shown gross of fees to get a sense of the goodness of the strategies. All produce the same outcomes as far as returns over the time frame but the diversified alpha portfolio has done so at much less volatility.



The significant comparative benefit of holding diversified alpha to beat index returns shows in the performance statistics. While all the returns are roughly on par over the last 20 years, the volatility of the composite HF index is much better than holding a defined outcome fund.

Source: Bloomberg, Innovator Funds, and Unlimited calculations

At Unlimited we are working to create products that deliver returns similar to a diversified portfolio of hedge fund returns using our return replication technology at fees that are close to that of defined outcome funds. Our goal is to offer products that give all investors the opportunity to reduce their risk using diversified alpha instead of trying to find improved performance through a less efficient structure like constrained beta.

It's also worth noting that defined outcome funds look worse than holding the stock market and cash in order to achieve a lower volatility relative to indexing. Below we compare the same 10% downside cap simulated defined outcome structure over a roughly 100 year period to the returns of the total stock market and also holding a 75%/25% stock market/cash portfolio (which matches the vol of the defined outcome portfolio). As you can see once you add in the 80bps fees from the defined outcome portfolio, the returns and Sharpe ratio are worse for the defined outcome fund simulation than just holding a stock/cash portfolio.


Source: Bloomberg, Fama and French Data Library, Innovator Funds, and Unlimited Calculations


In fact the last 20 years returns shown above are relatively unusual in the historical pattern of returns. The chart below compares the rolling 20 year returns of the 75/25 stock/cash mix to the returns of the -10% defined outcome structure. Over the last 100 years, the 75/25 stock/cash portfolio has consistently outperformed the defined outcome structure net of fees - and often by hundreds of basis points for decades. Betting on similar performance like what we have seen over the last 20 years is probably wrong, and will likely lead to significant drag over time.



Methodology Note: The returns of defined outcome funds are simulated based upon defined outcome funds pricing data from Innovator Funds over the last 5 years combined with Unlimited assumptions. It's uncertain how it would have traded in the past given market conditions at the time and so the returns of these strategies may have been better or worse than what is represented in this research piece. This research is meant for illustrative purposes only.