Buffer ETFs have grown rapidly over the past few years. According to statistics, since the first launch of these products in 2018, the number of U.S. market buffer ETFs has increased to 159, with assets under management reaching $37.99 billion. ETF.com. The core selling point of buffered ETFs for financial advisors is that these instruments provide clients with downside protection (typically from an initial 10% to 15% loss) while still allowing them to generate income from their investments in the stock market. This strategy is especially attractive during times of market volatility like the one we saw in 2022, when the S&P 500 fell 18.11%.
Jason Barsema, co-founder and president of investment platform Halo Investing Inc., said buffer ETFs, as well as structured notes and annuities, are important tools for financial advisors to protect client portfolios from unexpected market risks. All three products. “It’s a hedge against your long-term equity; it’s not some mysterious product that’s just shoved into the alternative investment drawer,” Balsema said.
He added that many advisors use buffer ETFs, structured notes and annuities as tactical tools, using them when markets are overvalued or volatile. “I think the complete opposite is that your portfolio should always be protected.” Barsema said some of the benefits buffer ETFs offer advisors compared to structured notes and annuities is that they are easier to rebalance in a model portfolio, providing day-to-day liquidity and reduce the counterparty risk present with other options.
However, the loss protection cushion that ETFs provide comes at a cost—when markets rise, investors’ gains are limited. Most of these products have a guaranteed results period of 12 months. Industry insiders say that if the market rises or falls slightly during this period, investors will reap the full benefits of these instruments. The calculation becomes trickier when there are large moves in the market, and the downside protection or return caps provided may be exceeded. The calculation also changes when an investor buys or sells a buffer ETF over the life of the series, rather than holding its position for the full term, because of downside protection and return caps that are set at the beginning of the series Terms no longer apply and are subject to market conditions. Experts warn that in this scenario, investors could still suffer huge losses or miss out on significant upside.
Lan Ahn Tran, a manager research analyst at Morningstar, said the buffer ETF has proven that its model works as expected. However, they may only be a good choice for certain investors, and their suitability in a portfolio depends on what the investor wants to achieve. “People may not fully realize what they’re giving up to get this downside protection,” she said. “It’s about use cases, and that’s where more education is needed.”
Tran noted that people who invest in buffer ETFs get a very narrow range of results, and they face limited downside and upside risk because fund managers of buffer ETFs have to limit returns to pay for downside protection. . For investors approaching retirement or those who cannot afford even small short-term losses, the protection they receive may be a worthwhile sacrifice in exchange for reduced risk, she said. On the other hand, clients with a long-term investment horizon and no immediate need for liquidity may achieve more significant returns by investing directly in the stock market or traditional ETFs.
While Barsema believes buffer ETFs are helpful for all types of investors, he does recommend that financial advisors pay close attention to the performance of these products, especially when using them in model portfolios. He noted that there are now hundreds of different series of buffer ETFs on the market, adding to the confusion that advisors may feel. “If you were actively rebalancing your vehicle portfolio, which range would you buy and which range would you sell? Advisors don’t want to fall into a ‘set it and forget it’ mentality. This buffer ETF has a ticker symbol. So I can rebalance at any time. There’s still a lot to do, as you need to make sure you’re rebalancing within the correct set. Failure to do so may have serious consequences. “
For example, if a financial advisor buys today a buffered ETF series launched in February with 10% loss protection and a 10% return cap, and the underlying index has risen 5% since launch, the client will only be able to hold another One Barsema points to upside potential of 5%. Meanwhile, if the index rises a total of 2% by the end of the ETF series, clients who started participating in April will ultimately suffer losses because their downside protection has not yet taken effect.
Barsema added that many advisors focus on the level of downside protection and upside cap provided by ETFs, without paying enough attention to when the series they participate in launches. “It’s important to know this: How much upside do I have left, and when do my protections really start to kick in?” he noted.
If market timing is bad, even investors who participate in a buffered ETF series throughout its lifetime may end up with underperforming products. Tran gave the example of someone who started participating in an ETF with a 20% buffer in December/January 2021. That person will ultimately be largely insulated from the market’s huge losses over the next 12 months, she noted. However, “if you buy at the worst-case scenario in 2022, maybe July or August, the market won’t really go lower. If you buy a fund with 20% protection then, by July 2023 or August, you miss out on the gains the market regained during those 12 months.”
Morningstar recently conducted a study that examined the rolling 12-month returns of the S&P 500 from its inception in 1928 through 2023. The study found that within these time frames, the index experienced losses of between 0 and 15% over approximately 15 years. % of the time, losses exceed 10%, and another 17% of the time, gains exceed 15% approximately 30% of the time. It turns out that buffer ETFs don’t completely protect investors from losses, but they often limit their upside.
At the same time, Morningstar found that investing in buffer ETFs incurs some additional costs compared to regular ETFs. Their fees are about 70% to 80% higher. Unlike the S&P 500, investors may forgo any dividends from the underlying stocks that own many buffer ETFs. According to Morningstar, these stocks have annual returns of between 1.5% and 2%. For these reasons, Tran said buffer ETFs may be best suited for nervous investors who have trouble staying in the stock market during volatile times and for investors who need easy access to liquidity.
“My advice to those with a long-term horizon is to stay invested in stocks for the long term. For investors with a 10 to 15-year horizon, the index fell 20% in 2022 and by January of this year, it was back to 2021 December levels. If you are able to continue to invest, I would suggest: you invest in buy and hold rather than trying to get too involved in equity.”
