A category of exchange-traded funds offering eye-catching coupons is creating buzz among the income-seeking set, but investors who want to dabble in these offerings should prepare to do their homework. Enter the autocallable ETF, an offering that aims to bring a strategy that's normally for the institutional set to the retail investor. These funds can tout weighted average coupons that are upward of 10% — but the mechanisms that are behind these rates are complex. "The yield is definitely one of the biggest draws to these products," said Zachary Evens, manager research analyst at Morningstar. "In the derivative income category, we're seeing more interest because investors are able to get these appetizing yields that can't be achieved in traditional asset classes or historically through other more broadly available products." Morningstar's derivative income category includes 260 funds and $182.77 billion in assets, which include covered call strategies like JPMorgan Equity Premium Income ETF (JEPI) . Autocallables are a subsector of this cohort, accounting for 19 ETFs with $2.25 billion in assets across the board, Evens said. Of these, the Calamos Autocallable Income ETF (CAIE) is the biggest, approaching $1 billion in assets and its one-year anniversary on the market. The FT Vest Laddered Autocallable Barrier & Income ETF (ACYN) is in a distant second with $615 million in assets, according to Morningstar. Even as autocallable ETFs may show up in a chassis that's familiar to retail investors, their structure may be confusing to the uninitiated. "I can't stress how complicated these products are and how unfamiliar traditional ETF investors might be with the concepts of these products," Evens added. A boutique income strategy These ETFs aim to bring a strategy once reserved for institutional investors to the retail investor. Banks issue autocallable yield notes, which are issued for a certain term, use embedded options and are tied to the performance of an underlying index or asset. This note will pay a coupon if the index or asset meets a set of conditions, like staying above a stated level. These notes tend to mature in five years, and the issuer can call them after a year if the index is at or above its initial level. The notes also offer some level of downside protection, meaning you get your coupon payment if the underlying index doesn't fall below a certain percentage – known as a barrier. Autocallable ETFs use a portfolio of these yield notes, which makes them accessible to the individual investor. Though investors may find the prospect of large yields enticing, the income isn't guaranteed. There are circumstances in which a note may not make a coupon payment or you may see your principal decline. This can be the case if your underlying asset sees a sharp and lengthy downturn that takes it below the negative barrier. While this explanation generally covers how autocallables work, investors getting into the space need to have an intimate understanding of how their fund operates. "Each one is a bit different, so investors must understand where those different levels are within their ETF to fully grasp what the risks are," said Evens. To add a new element of complexity, some autocallable ETFs follow a single stock, he added. Where does it fit? Investors gravitating toward these funds may see them taking different roles in their portfolio. "Someone with a large unrealized gain position who wants structured downside exposure, and isn't relying on the distribution as real income may have a reasonable use case," said Jeff Judge, certified financial planner at Chesapeake Financial Planners in Forest Hill, Maryland. He said that with his client base of pre-retirees and high-income earners searching for yield, autocallable ETFs have come across his desk more than once in recent months. These offerings typically require a lot of education for investors. "Whenever people hear 'yield,' they think 'fixed income,' and that isn't the case with these," Judge said, noting that investors can overlook the risk of principal loss in extreme downturns. "It's not income in the traditional sense of the word." Investors and their advisors ought to model how the ETF might react in different scenarios, and they should also think about what portfolio problem they want to solve by adding these funds, he said. Revisiting asset allocations and risk appetites might get at the heart of what investors are trying to address. Fees are also a consideration. Autocallable ETFs on the market have expense ratios that average at 0.88%, according to Morningstar. As always, higher costs can chew up your portfolio's returns. "Really dig into it because it's a newer option instrument," said Judge. "The biggest thing is to know what you own, and if you don't understand it, don't buy it."
