Portfolio Management

Investment Approach

Buffer ETFs

More than $10 trillion is invested in exchange-traded funds (ETFs) worldwide. The transparency of the ETF investment vehicle has made it appealing to investors for all portfolio sizes. Daily liquidity, tax efficiency, lower fees and transparency make it highly utilized.

According to Morningstar, Buffer ETFs are one of the fastest growing segments of the ETF marketplace. Assets have grown from $200 million in 2018 to over $35 billion, and there are now over 160 Buffer ETFs trading on U.S. markets. Their popularity has skyrocketed. These ETFs track a stock market index over a defined outcome period while offering downside protection, known as a “buffer.” Investors can also participate in the upside of the stock market, to a predetermined cap.

Buffer ETFs allow investors to participate in stock market gains while also setting a predetermined level of downside protection – typically the “buffer” protects against a 9-10%, 15-20% or 25-30% loss, depending on the Buffer series you own. So, you can customize your portfolio and choose how much protection to purchase over the outcome period, which is typically 12 months.

Obviously, there is some cost involved when owning an investment that offers downside protection. The “cost” with Buffer ETFs is a potential missed opportunity – your investment gains are capped for the subsequent 12-month period. Still, most of the recent Buffer ETFs that offer protection on the first 15% loss, have had a high upside cap of at least 14% (gross of fees), which is pretty darn attractive over a 12-month period. Having 14% upside potential with 15% downside protection offers a very attractive risk-reward opportunity in nearly any market environment.

Buffer ETFs don’t actually own stocks, rather they use options to track the performance of an index (e.g. S&P 500). Most Buffer ETF wrappers hold four option contracts and the ETFs reset every 12 months (automatically roll to the next 12-month period) with new downside protection and a new upside cap too. Although Buffer ETFs trade daily just like individual stocks and other ETFs, they are designed to be held as long-term investments.

If you are nearing retirement or already in retirement and you’re worried about stock market losses, the protection provided by Buffer ETFs can give you some comfort and also allow you to stay invested even during difficult markets.

Regardless of your age, if you are a defensive-minded investor more concerned about not losing money than hitting a home run, you’ll likely find Buffer ETFs very appealing. Many investors would rather have a level of downside protection and give up some upside, than have full exposure to losses if the market takes a tumble. The layer of protection can be very attractive.

What are the advantages to owning Buffer ETFs?

Buffer ETFs allow you to participate in the stock market, but with downside protection. Buffer ETFs trade like stocks and other ETFs with daily liquidity and transparency. Unlike many structured products, like annuities, there are no lock-up periods or surrender charges. And, there is no credit risk. Last, most Buffer ETFs automatically reset (new protection and a new upside cap), in a tax-efficient manner, after each 12-month outcome period, and can therefore be held as long-term investments.

What are the disadvantages to owning Buffer ETFs?

Buffer ETFs aren’t a perfect solution in every stock market environment. The risks are at the extremes. If you buy a buffer series that offers 15% downside protection, but the market falls 25% over the outcome period, you’ll lose the difference, or 10% (plus the ETF’s advisory fee). And, if the market soars coming out of a correction or bear market, but your upside is capped, you’ll forego some potentially high returns. Still, the ability to participate in the stock market, up to a cap, but with much-needed protection, should appeal to most investors.

Buffer ETFs offer the best of both worlds: stock market participation with a buffer against downside losses.
Learn more about Buffer ETFs in our educational section.

Stocks

If you follow a buy-and-hold strategy, as suggested by most Wall Street firms and their advisors, you can expect a bear market to do significant damage to your portfolio every 6 years or so, on average. A bear market is defined as a loss of at least 20% and they happen quite frequently – and the average stock market decline during a bear market is pretty harsh – approximately 30%. In the past 25 years, many buy-and-hold stock investors have seen considerable damage done to their portfolios as markets have experienced declines of 50% or more not once, but twice.

A buy-and-hold approach does not appeal to me as an advisor and is unacceptable for the vast majority of my clients. Again, since most of my clients are either nearing retirement or in retirement they do not want a passive advisor or money manager who will not take steps to try to control risk (and losses) during a bear market. Bear market losses can indeed be devastating to a portfolio and it can take many years for a portfolio to recover – often 5 years or more – and in the case of the Great Depression it took over 25 years for prices to recover. And, of course, the way the math works makes it particularly challenging to recover from significant losses. A loss of 30% requires a gain of 43% to break even. A loss of 40% will take a gain of 67% for your portfolio to recover – you get the point. Again, it can take many years for new bull market gains to make up for the devastating losses of a bad bear market – not ideal for anyone nearing retirement or already retired.

Buy-and-hold makes little sense for retirees:

• Buy-and-hold cannot bring you a stable and safe return in retirement. This has already been proven time and time again by many bear markets throughout history as they have inflicted damage on portfolios. Declines of 20% or more in the stock market are to be expected, and, again, declines of 50% or more have happened twice since 2000.
• Buy-and-hold requires you to purchase stocks while ignoring valuations. How can this make sense? Why would you ignore the price of anything you purchase, including stocks? An advisor who suggests a buy-and-hold approach will typically allocate a certain percentage to stocks, bonds and cash (e.g. 65% – 30% – 5%) regardless of valuations or price, and then simply bring the allocation back to the initial target on a quarterly or annual basis. But, this does little to protect against large losses during a bear market. Again, price always matters and this overly simplistic approach to asset allocation, that doesn’t factor in stock valuations or current risks, is flawed.
• If you are nearing retirement or already retired, buy-and-hold can be disastrous to your financial health. We saw this during the devastating bear market in 2000-2002 and again in 2008-2009 when stock losses for the broad averages reached 50%. Similar declines going forward, or even average bear-market losses, for a passive investor, could again delay retirement or ruin plans to buy a home or fund a college education for a child or grandchild.