Rising inflation and interest rates could send the economy into a recession. Unfortunately, high correlations between asset classes leave investors with few safe havens. As a result, some investors are starting to rethink conventional asset allocations and look at more creative ways to protect their portfolios, like buffer ETFs.
In this article, we will take a look at buffer ETFs, their pros and cons, and some popular options for your portfolio.
See our Active ETFs Channel to learn more about this investment vehicle and its suitability for your portfolio.
What Are Buffer ETFs?
Buffer ETFs, also known as defined outcome ETFs or structured ETFs, enable investors to forego some upside potential for protection against some losses. Over the past three years, the number of buffer ETFs has grown to more than 120, with more than $7 billion in assets. That’s more than any other type of liquid alternative ETF.
Under the hood, these funds are actively managed for selling call options to create a price ceiling and buying put options to establish a price floor. So, there’s a guaranteed buyer at the put option’s strike price, but the call option’s strike price caps the upside. And, given the nature of stock options, the protection occurs over a defined period (usually one year) with specific start and end dates.
The amount of protection and protection period varies from fund to fund. For example, the Innovator S&P 500 Buffer ETF (BJUN) tracks the S&P 500 index and protects investors from the first 9% of losses between June 1, 2022 and May 31, 2023. However, the maximum upside over that period tops out at 19.7%, and the fund has a 0.79% expense ratio.
Buffer ETF Pros & Cons
Buffer ETFs have obvious benefits during volatile or uncertain markets. In particular, the funds are a popular option when the bond market underperforms. Retirement investors who want to preserve capital, but can’t rely on the bond market, may use buffer ETFs to limit their downside and ensure they have enough money to meet their retirement needs.
However, there are a handful of trade-offs to keep in mind:
- Expense – Buffer ETFs typically have a 0.8% expense ratio, making them much more costly than ETFs covering the indexes they track. These annual expenses reduce current returns and eliminate the potential for that capital to compound over time.
- Dividends – Buffer ETFs don’t hold any underlying stocks, meaning investors don’t receive dividends. While option prices should theoretically reflect dividends, investors could have lower returns in reality due to the lack of income.
- Bullish bias – The stock market tends to rise over time. As a result, buffer ETFs could sacrifice upside returns more than they benefit from downside protection. Investors could be better off with a conventional asset allocation over the long term.
Notably, buffer ETFs could become more or less attractive over time. For example, suppose the stock market falls sharply and a buffer ETF has only 2% downside protection left. In that case, investors have little reason to purchase it over a conventional lower-cost fund. On the other hand, the opportunity cost may be too high if the price is near the cap. Here are some of the popular buffer ETFs.
| Fund Name | Ticker Symbol | Expense Ratio | Total Assets |
|---|---|---|---|
| Innovator US Equity Power Buffer ETF - January | PJAN | 0.79% | $537 million |
| Innovator US EQuity Power Buffer ETF - May | PMAY | 0.79% | $411 million |
| FT CBOE Vest US Equity Deep Buffer ETF - November | DNOV | 0.85% | $377 million |
| Innovator US Equity Power Buffer ETF - July | PJUL | 0.79% | $369 million |
| FT CBOE Vest US Equity Buffer ETF - May | FMAY | 0.85% | $353 million |
Data as of July 12, 2022
The Bottom Line
Buffer ETFs could play a critical role in investor portfolios, particularly when the bond market underperforms. However, investors should be mindful of the higher costs and other downsides. Younger investors with longer time horizons may be better off in lower-cost index funds to avoid sacrificing upside potential over the long term.
Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.
