Definition, Strategy, Risks, and how Buffered ETFs Work
Buffered ETFs have been around since about 2018. The idea: you have some downside protection and a chance at growth. Does that sound familiar? Yup another structured product!
These buffered ETFs are hedges against some investor’s behavioral issues, and can be utilized in different ways.
What are Buffered ETFs? Instead of being wrapped in annuity form (which are most commonly FIAs, but also the new dog on the block—RILAs), or sold by banks or broker dealers as structured products, these are actual ETFs. ETFs have many advantages over annuities and broker sold products.
The definition of a buffered ETF: an exchange traded fund that uses derivatives to limit the downside by capping the upside of an index. The goal is to provide this cap and buffer over a defined period of time. As an ETF, they are tax-efficient, flexible, and liquid.
Instead of owning the stocks, you have options on them. The result: you might get less pain, but the cost is potentially a lot less pleasure! Let’s learn about the strategy, risks, and how buffered ETFs work.
How Buffered ETFs Work
Buffered ETFs have some downside protection which comes at the cost of a limited upside. Usually, the protection is for a defined period of time, say one year, but you can exit early, enter late, or roll-over into the next buffered ETF (which defers taxation of potential gains).
This is how buffered ETFs work:
You buy a call option on an index (such as the S&P500) which, if the market goes up, lets you buy the index in the future at today’s prices. This gives upside! On the other side of the call option are folks who are writing the calls for income, who presumably are ok at selling at higher prices in the future.
That part is easy to understand. The buffer is more complicated! The buffer involves buying and selling puts to “buffer” part of the downside, but also selling a call option above the cap. This is complicated, but the reason for these 3 options is singular: to provide income to buy the original call option.
So, in order to get income, Buffered ETFs sell calls above the cap, and sell puts below the buffer. This caps the return, but funds the put to provide the buffer.
Fundamentally, buffered ETFs buy and sell options above and below both the cap and buffer in order to provide income which then hedges the downside.
Ok, you don’t need to understand exactly how a buffered ETF works, but remember the paradigm that complexity favors the seller rather than the buyer. Buyer beware! Understand how these products might work in different situations and you can forget the mechanics behind them.
So, to summarize, you get the upside up to a cap, and you get a downside buffer until a certain level, and then you start participating in the downside again. Limit up, and no down unless it is down a lot. The cap is the cap. The buffer takes away some of the initial pain of a down market, but only to a certain point.
Let’s look at how Buffered ETFs work.
Show Me How Buffered ETFs Work
Let’s look at a graph of how Buffered ETFs work.
Above, on the Left, you can see a 15% buffer ETF. The dotted arrow are the possible returns of the index, and the solid arrow reflects the possible returns of the buffered ETF.
Start at the center. As the market goes up, you get the positive return until you hit the cap, then there is no more return (so the arrow goes horizontal).
On the downside, there is no loss on the first 15% of the index’s losses. That is why the solid arrow stays at zero. Once the loss is more than 15%, you start participating in the loss. So, if the index is down 15% during the coverage period, you lose zero. If it is down 20%, you lose 5%. If it is down 50%, you lose 35%, and so on.
On the Right, let’s look at a little more complicated buffer. It is a 30% buffer, but to make it more affordable, it doesn’t kick in until there is more than a 5% loss.
You can see the upside is the same; there is a cap.
The downside, however, you participate in the first 5% of the loss, then there is no more loss until the index is down 35%. So, if the index is down 5%, you lose 5%. If it is down more than 5 but less than 35%, you only lose 5%. If it is down 50%, you lose 20% (because there is a 30% buffer). Isn’t this fun!
Next, how might you use buffered ETFs?
How to Use Buffered ETFs
What are the use cases for buffered ETFs?
Use a Buffered ETF Instead of Cash
Do you have a lot of cash laying around? If you don’t mind losing some if there is a large downturn in the market, but want more than money market returns (which are zero point nothing right now), you might put some of your cash into a buffered ETF.
The behavioral misstep we are attempting to correct here: folks have way too much money in cash and just cannot get invested. With a Buffered ETF, at least you have an upside instead of staying in cash!
The risk using this strategy is that you still sell once you are below the buffer, so you can still be a big looser with this strategy.
Use as a Bond-Alternative
You might see this called “liquid alts.” Use a Buffered ETF to try and generate more return from your bond-part of the portfolio, while you still have some downside protection.
While there still is correlation between buffered ETFs and a major down market, one might expect better returns with a buffered ETFs than with bonds. Buffered ETFs are a potential bond-alternative.
The use cases here is for folks who are more conservatively invested than they “should” be. The risk, of course, is that you dump this fund when the market is below the buffer and lose out, instead of just holding on to your conservative portfolio.
Use a Buffered ETF during your Pre-Retirement Glidepath
As mitigation to sequence of returns risk, you might consider a buffered ETF as part of your pre-retirement Glidepath. As a reminder, sequence risk is greatest the five years before and 10 years after you start withdrawals from your portfolio.
As you start transitioning from accumulation to de-accumulation, you can put part of your transitional portfolio into buffered ETFs to partially hedge against sequence risk.
For instance, five years out, you might put 10% of your stock portfolio into a buffered ETF. The next year, you might buy 10% bonds. In the final year, you would sell your buffered ETF and move into bonds.
Use of Buffered ETF as Part of a Bucket Strategy
If you have a bucket strategy, you might consider having your money for 2-4 years out partially in a buffered ETF.
Reduce Volatility and De-Risking with Buffered ETFs
De-risking prior to retirement is very important. If you are, say 80/20 and are on your way to de-risking, you might consider taking a “slice” of your asset allocation, say 10% of your stocks and 10% of your bonds, and putting that chuck into Buffered ETFs.
So, then in the example, you would be 80/20 on your way to 60/40, you might do 70/20 with 10% in a buffered ETF for a few years.
Just an idea. But a complicated one at that.
You are Nervous About the Stock Market and Cannot Tolerate Being Invested in Anything Else
This is not a great reason, but some folks are so nervous that the usual suspect (diversification) doesn’t help them.
If the alternative is all cash all the time, a buffered ETF is better than nothing. But just a little better! At least over the last 3 years, buffered ETF have not out performed a 60/40 portfolio.
Do Not Use as Equity Equivalent
If you have time on your side, invest in actual low-cost index funds and hold them long term. The major downside of buffered ETFs is they massively lose out to the indexes over longer periods of time. They are not equity equivalents.
Where do I Find Buffered ETFs?
Innovator has been around the longest. First Trust and Allianz also have products.
How Much do Buffered ETFs Cost?
The expense ratio for most of the funds are between 0.7 and 0.9%. So, they are not that expensive.
The real expense is the underperformance you get in these funds compared to if you actually are invested in the index. If you can stomach the downturns—and not commit the cardinal sin of investing (selling low)—then you are much better off with simple plain-old buy and hold low-cost indexing.
As you know, no one knows next year’s market returns. Positive most years, but negative 3 times out of 10 on average.
The point is: you should not care! That’s right, who cares what the returns are next year? You should only care twice what the price is: what it is when you buy it, and what it is when you sell it.
This is why I suggest you use total market ETFs rather than individual stocks: You buy when you have money and you sell when you need money.
But let’s be honest. Some people cannot not look at the daily, weekly, or yearly market moves. Some will panic sell. Is a buffered ETF better than panic selling? For sure! If you can stay invested in a buffered ETF and otherwise would have sold low and locked in losses, then by all means consider buffered ETFs.
So, these products may be best for folks who have panic sold and are now in cash and don’t know what to do—when to get back in. Instead of dollar cost averaging back in, why not buy a buffered ETF? Downside protection. Check. At least some exposure to the upside (or at least more than cash). Check. What is not to like?
It is better than the alternative out these: structured notes. These are even more expensive, illiquid, and tax-inefficient.
And please consider a Buffered ETF instead of an FIA or a RILA. Please! Please!
Also Known As: Other Names for Buffered ETFs
- structured ETFs
- defined outcome ETFs
- target outcome ETFs
- buffered outcome ETFs
When You Purchase Affects Price and Performance
Remember that the option contracts usually last for a year after the buffered ETF is formed, so the price and the buffer/cap change over the course of the year. You can go the the website and see how what the cost of a, say, 6-month-old fund is doing, and how much of the buffer and cap are left.
Thus, it is important to figure out if you want to buy in at the beginning of the contracts, or if you want to mess with them intra-year and intra-contract. In order to know the right thing to do, you need to be able to predict market returns. If you could do that, you wouldn’t need buffered ETFs in the first place!
What Happens at the End of a Its Life?
After a year, the contracts expire. If you stay invested, you roll into the new buffer ETFs cap and buffer.
If you sell prior to the end, you get the price of the ETF. You are taxed and short- or long-term capital gains rates.
Taxation and Buffered ETFs
As you know, ETFs are tremendously tax efficient. There should be no distributions during the year. Even more exciting, even though options are usually taxed at ordinary income rates, buffered ETFs should be taxed at capital gain rates. If you hold for a year and a day, you get long term capital gains rates.
Summary– Definition, Strategy, Risks, and how Buffered ETFs Work
Buffered ETFs should not be used by folks who will never sell low. If you don’t have a problem with panic selling, just don’t bother with these products!
But if you have sold low in the past, or are looking to de-risk your portfolio or invest cash that you otherwise would leave sitting in the mattress, a buffered ETF is worth consideration.
The risk to buffered ETFs is not the product, it is you! Behavior is everything in investing. Buffered ETFs are subject to losses with a massive downturn. More importantly, however, they should not be used as equity alternatives because the largest loss is the loss of participation in the years where there are large positive gains.
Some may say that they cannot stomach any loss of principle. You can argue with these folks until you are blue in the face, but they might be better in a structured annuity with actual downside protection (such as a FIA).
Structured products are complicated, and you can buy them, or you can be sold them. If you need a structured product because of your potential for bad behavior, a step down from annuities (not in complexity but perhaps in costs including illiquidity) are buffered ETFs.