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Volatility, investor climbing rising market, balance, VIX

Portfolio > Portfolio Construction > Investment Strategies

In Today's Volatile Markets, Buffer ETFs Could Offer Peace of Mind

By Dinah Wisenberg Brin

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What You Need to Know

  • Such products limit both potential downside losses and upside gains.
  • In July, 289 defined outcome ETFs totaling $41.4 billion in net assets traded in U.S. markets,
  • Innovator and First Trust are the top two buffer ETF providers by assets, according to Morningstar.

Many investors undoubtedly experienced panic-driven adrenaline rushes Monday as U.S. stocks sold off sharply, with the S&P 500 experiencing its biggest drop in almost two years.

Even though the index managed a strong rally Thursday, clients aiming to avoid the stress associated with heart-pumping sell-offs may be interested or already in buffer exchange-traded funds, which limit both potential downside losses and upside gains.

“Buffer ETFs can add ballast to a portfolio. Over the past couple weeks, buffer ETFs have been tested with significant volatility,” Rachel Aguirre, U.S. head for iShares products at BlackRock, told me by email Friday. 

“These products are delivering a way for investors to step out of cash in their portfolios, providing access to equity growth up to a return cap, while protecting against market drawdowns,” she said.

BlackRock recently announced a series of buffer ETFs, among the latest addition to an expanding universe of such funds, which have surged in recent years.

On a Tear

In July, 289 buffer, or “defined outcome,” ETFs totaling $41.4 billion in net assets traded in U.S. markets, according to Morningstar data. That compares with 221 ETFs and $34.1 billion in assets in January, and 150 funds with nearly $14.3 billion in July 2022.

In August 2019, there were only 23 buffer ETFs with nearly $1.3 billion in assets, Morningstar reports.

The growth in buffer ETFs isn’t just a recent phenomenon, although it’s certainly received more headlines in the wake of market volatility, Zachary Evens, Morningstar Research Services manager research analyst, told me Thursday. The growth since 2022 has been driven partly by higher interest rates, he said.

“The fund managers are able to offer a cap and buffer” that’s appealing to investors,” Evens explained.

“The market volatility in 2022 brought a lot of investors into this space as they saw their portfolios drop by 20%, maybe even 30% that year, where these products offer them a relatively defined range of outcomes,” Evens added.

The Secret Sauce

For investors with a short time horizon or who are risk averse, buffer ETFs are fairly effective at reducing equity market risk while retaining some stock exposure, he noted.

These funds typically take a long position in a broad index-based fund like the SPDR S&P 500 fund, and also buy and sell options to protect investors from losses up to a certain point, he explained.

In simple terms, a buffer ETF advertising a 10% downside buffer would result in only a 5% loss for investors if the market dropped by 15%, assuming they hold the fund throughout the designated outcome period. 

To pay for that protection, the ETF effectively caps the index’s upside; if the cap rate is 10% for the outcome period and the S&P 500 gains 15%, the investor will realize only 10% of the gains in that period, Evens said.

Concerns With These Funds

While buffer ETFs may suit some investors, they’re not without potential downsides.

For one, these funds are often more expensive than more standard ETFs, typically bringing a 50- or 100-basis-point expense ratio, according to Evens. 

“Cost is definitely a drawback. You are effectively, with these, realizing low beta exposure to stocks. If you want low beta exposure to stocks, you can achieve that in other ways for a lower expense ratio. You can put together a portfolio of low-cost, index-based ETFs for less than 10 basis points and achieve similar beta exposure,” the Morningstar researcher said.

Investors also need to pay attention to the designated outcome period, Evens added. 

“If they hold it for less than the outcome period, or not the exact outcome period that is stated on the provider’s website, they’re not going to realize the defined outcome that is advertised,” he said. “They start at a reference point and then those options are sold or bought with an expiration.”

In other words, “you have to buy it on day one of the outcome period, and then you have to either sell it on day 365 or however long the outcome period is, or you can keep your money in it as well if you want to maintain exposure,” Evens said. 

“I know the providers have been trying to do a lot of education around making sure investors and advisors know that they need to buy this on day one and hold it through the entirety of the outcome period.”

In addition, buffer ETFs generally quote gross capped rates, so investors would reach a return minus the 50- or 100-basis-point fee, he said.

Innovator and First Trust are the top two buffer ETF providers by assets, according to Evens.

During the recent stock market selloff, buffer ETFs fared better than the market overall, he said.

“Last Friday (Aug. 2) and this Monday, these products as a whole did better than their reference asset, and that’s just an outcome of their kind of relatively low beta exposure to whatever that reference asset is,” Evens said. “So if the S&P 500 lost 5%, a buffer ETF could have lost about 3%.”

Intra-period market swings, however, don’t matter that much, Evens suggested: “The only thing that matters is where it ended up at the end of the year relative to the cap and buffer, and then that is what the investor will realize.”

Dinah Wisenberg Brin

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