Downside Protection with Upside Potential in Buffer ETFs
Most investors find losses much more distressing than missing out on potential gains. One of the fastest growing segments of the ETF (exchange-traded funds) marketplace now offers a potential solution. Since 2018, over 160 Buffer ETFs have been launched, and they have attracted over $30 billion in assets. Most Buffer ETFs are offered by either Innovator ETFs (www.innovatoretfs.com) or First Trust (www.ftportfolios.com). BlackRock has also recently issued its own iShares Buffer ETFs.
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%, 15% or 30% loss, depending on the Buffer series you own. So, an investor can customize a portfolio and choose how much protection to purchase over a “defined 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 15%, which is pretty darn attractive over a 12-month period. Having 15% upside potential with 15% downside protection offers a very attractive risk-reward opportunity in nearly any market environment.
How do Buffer ETFs work?
Buffer ETFs are a bit complicated and require some explanation. They don’t actually own stocks, rather they use options to track the performance of a stock market 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.
There are typically three option layers in a Buffer ETF:
- The ETF purchases exposure to a stock market index with a call option.
- The ETF creates downside protection (a buffer) by purchasing a put option.
- The ETF sells options to finance the cost of the protective put. Typically, the ETF will sell both a put and a call option. The put option will set the amount of protection over the outcome period and the sale of the call option “caps” the upside potential gain. These sales are necessary to offset the cost of the purchase of the put option that provides the protection.
Too complicated? Well, you don’t have to understand the intricacies of the options market to benefit from owning Buffer ETFs. The ETF issuers manage the options for you, within the ETF wrapper, which makes Buffer ETFs appealing to both unsophisticated and seasoned investors.
What type of investor could benefit from owning Buffer ETFs?
- You are worried about potential stock market losses.
- You are a retiree or pre-retiree wanting to take less risk, but still participate in the stock market.
- You are a conservative or moderate-risk investor.
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.
For the first time in my long career as an investment advisor, the availability of Buffer ETFs has given me, and more importantly, my clients, some peace of mind. We can participate in the upside of the stock market, but also have some built-in protection in place.
If you want to participate in stock market gains, but with downside protection, Buffer ETFs may be a perfect fit for your portfolio.
At the time of publication, Stuart Chaussee and/or his clients held positions in the following Buffer ETFs: BJAN, GAPR, PAUG, PJAN, PJUL, PMAR, PMAY, PNOV, POCT and PSEP. Holdings can change at any time. Under no circumstances does the information in this column represent investment advice or a recommendation to buy or sell securities. Chaussee can be reached through www.preservingwealth.com or at stuartchaussee@msn.com
