BUFFER ETFS PROVIDE A DEFINED LEVEL of protection against losses. You can also think of this as “insurance.” The insurance premium, or the cost you pay, is having your return potential capped over the outcome period, which is typically one year. The cost of the protection changes depending on market volatility and interest rates, which affect the upside caps.
Your preferred buffer level will depend on your risk profile and other factors. Do you want protection against the first loss of 9%, 10%, 12%, 15% or 20%? Or, do you want an even deeper buffer? If you are very risk averse, you can even purchase 100% downside protection with Innovator’s Equity Defined Protection ETFs.
In normal market environments, I think the cost (upside cap) is reasonable. For example, let’s say you purchase a 15% Buffer ETF series that offers upside participation in the S&P 500 to a cap of 14%. Any gain by the reference asset beyond 14% at the end of the outcome period will not be captured – it’s effectively forfeited. That’s your “cost” for the downside protection – your upside gain potential is capped over the 12-month outcome period. But, in a “normal” market environment, wouldn’t you be happy with a 14% annual return?
The downside protection allows you to buffer your position against the first 15% loss (before fees), over the outcome period, which in any market other than a bear market, would likely be enough protection to shield you from loss.
The appeal of Buffer ETFs, and the protection they provide, is all about the opportunity cost. If the upside cap is attractive, which to me would be a cap that is at least as high as the average annual historical return of the stock market (10%), then the protection is likely worth the cost. A 15% buffer provides protection against the first 15% decline in the reference asset, and that’s a lot of protection in nearly any market environment. If the potential upside is at least 10% net over the outcome period, then I think it’s worth considering a purchase.
Sure, the attractiveness of any Buffer ETF will depend on the market’s current trend too and where we are in a market cycle. Are we in the middle of a bear market or are prices well into a bull-market run and valuations stretched? This could greatly influence how much protection you want or whether or not you want any protection at all. If valuations are high, or even in the normal historical range (16x PE for the S&P 500), I’d argue the protection is likely worth the cost. But, if we are in the throes of a bear market or crash, and stocks are already trading down 20% or more, then you might not want any protection at that point. The opportunity cost (capping the upside) could potentially be too expensive if the reference asset surges coming out of a steep decline.
Most of the investors I’ve talked to are very interested in the portfolio protection that Buffer ETFs provide, as long as the upside caps are equal to or higher than the average annual historical return of the U.S. stock market. Thankfully, in recent years, most Buffer ETFs have offered upside gross caps of 14% or more, with downside protection of 15%. This is a pretty attractive risk vs. reward opportunity for most investors, and likely worth the cost of the protection.
Is the cost of having portfolio protection with Buffer ETFs worth it for you?
Your decision to purchase portfolio protection through Buffer ETFs should depend on your current outlook for the stock market, and more importantly, your tolerance for risk. If you are a conservative or moderate-risk investor, you may always want some level of downside protection in your stock portfolio. If you are an aggressive investor who can stomach a 30% decline (or more) in the value of your stock portfolio during a bear market or crash, then you may decide you never want any protection because you don’t want to cap your upside return potential.