‘Boomer Candy’ Funds: Sweet Treats or Investment Toothache?

The Name Game

Last week, The Wall Street Journal published a feature entitled “These Hot New Funds Are ‘Boomer Candy’ for Retirees,” proving once again that professional headline writers are cleverer than me. (But not more grammatical; if you don’t like the previous sentence’s construction, read this.)

The phrase is not only catchy, but it neatly summarizes the funds’ appeal. The young frequently court danger, dabbling with cryptocurrencies and meme stocks, but their parents tend to be less brave. Rather than assume greater risk in the hope of earning higher returns, older investors prefer a tamer path. Give them securities that act mostly like stocks while being less volatile.

Enter “boomer candy.” The Journal uses the term to describe two varieties of exchange-traded funds. Each flavor, regrettably, has multiple names. One is dubbed “covered call,” or “equity premium income,” or (by Morningstar) “derivative income.” The other group is usually referred to as “buffer” but is sometimes called “structured.” It currently lands in the options-trading Morningstar category. In October, though, such funds will be moved to their own category: defined outcome.

For the remainder of this column, I will use Morningstar’s nomenclature: derivative income and defined outcome.

Derivative Income

Ongoing payouts are the charm of derivative income funds. They buy equities, concede some of their stocks’ potential upside by selling call options—or the equivalent thereof—and then distribute the cash they receive from those trades. (That is the Reader’s Digest version of a considerably longer story. Those interested in a fuller version may wish to read these articles.)

Regrettably, because the funds use diverse tactics, their yields are not comparable. For example, 17 fund families manage derivative income funds that report SEC yields. (Not every fund discloses that figure.) The chart below displays each family’s highest-yielding fund according to that measure—which, per the commission’s rules, must be calculated in standard fashion.

All over the map! Yet despite the apparent range in stated yields, almost all those funds make generous ongoing distributions. For example, the lowest-ranking fund on the SEC yield list, at a pitiful 0.23%, Nationwide Nasdaq-100 Risk-Managed Income ETF NUSI, pays a 7% annual dividend.

Determining payouts thus becomes a laborious chore of summing each fund’s 1) income distributions, 2) capital gains distributions (both short- and long-term), and 3) return-of-capital payments. Good luck with that!

Defined Outcomes

In contrast, defined outcome funds rarely make significant distributions. (The exception is the “Premium Income” series from a fund provider named Innovator.) Their boomer candy consists instead of downside protection.

Typically, defined outcome funds achieve their goals by selling call options on their equity portfolios, as do derivative income funds. However, unlike the latter, defined outcome funds also purchase put options to protect against stock market declines. In summary, both categories of funds mortgage their futures by selling some of their potential gains, but while derivative income funds immediately distribute the proceeds, defined outcome funds reinvest those moneys to guard against potential losses. Grasshoppers and ants.

The number of possible combinations that defined outcome funds can achieve rivals the number of grains of sand on a beach. To cite two examples, Calamos S&P 500 Structured Alt Protection ETF—May CPSM was launched with a 12-month guarantee of returning between 0% and 9.81%. For its part, FT Vest US Equity Deep Buffer ETF—January DJAN capped its gain at 13.9% while safeguarding against one-year losses from 5% to 30%. (But not against lesser or greater deficits.)

The performance contracts are temporary, but the funds are forever. After their guarantees expire, the funds reboot their terms. In addition, shareholders are not restricted to buying defined outcome funds during an initial window. As ETFs, such funds are continually available, resetting their investment promises in response to the prevailing market conditions.

Defined outcome funds directly address arguments that I made in a May 2023 article entitled “Structured Products: Right Idea, Wrong Execution.” The concept is not new, as securities that deliver defined investment concepts have existed for decades. However, they traditionally have been offered through private securities issued by banks. In that article, I complained that such investments bore counterparty risk, could not easily be traded, and were difficult to research. In addition, their expense ratios were hidden.

By relocating the strategy into ETFs, those problems have been resolved.

Scoring the Performance

While ongoing payments and downside protection are attractive features, boomer candy ultimately must be judged against the investment alternatives. After all, one could place cash underneath a mattress, withdraw 1% of that amount monthly, and enjoy 12% annual “income” while also being protected against stock market losses. That would not, however, be a wise investment.

In that light, I present the trailing three-year performance for 1) derivative income funds, 2) defined outcome funds, and 3) balanced funds, as represented by Morningstar’s moderate-allocation category. I also include a homemade alternative consisting of 60% US stocks and 40% Treasury bills.

(I would have preferred a longer evaluation period, but these fund categories are very new.)

The good news for boomer candy is that both fund categories thrashed their main competition, balanced funds. The bad news is that they slightly trailed a straightforward stock/cash combination, which suggests that their triumph owed more to bonds’ unprecedented recent woes than to their own virtues.

That said, I have no quarrel with boomer candy. Normally, I object to funds that employ complex strategies, as they usually carry high expense ratios and perform erratically. However, because these are ETFs, most of these funds are reasonably priced (annual expense ratios of about 0.75%). And although derivative income funds can occasionally surprise, defined outcome funds do what they promise. Overall, these are relatively predictable investments.

I would not buy these funds. When possible, choose simplicity! But I will not lecture those who do. They are unlikely to develop cavities.