Buffer ETFs can protect investors from losses. This comes at a cost.


Last years seen rapid growth in buffer ETFs. According to ETF.com. The central selling point of buffer ETFs to financial advisors is that these vehicles offer clients downside protection—typically ranging from 10% to 15% of their first losses—while allowing them to reap investment gains in stock market. This strategy can be especially attractive during periods of market volatility of the kind we saw in 2022, when the S&P 500 posted a loss of 18.11%.

Buffer ETFs, along with structured notes and annuities, serve as an essential tool for financial advisors to protect their clients' portfolios from unexpected market risks, according to Jason Barsema, co-founder and president of investment platform Halo Investing Inc., which specializes in all three of these products . “It's a hedge against your long-term capital; it is not some mystical product that goes into the drawer of alternative investments,” said Barsema.

He added that many advisers use buffer ETFs, structured notes and annuities as tactical tools, using them when the market is overvalued or volatility is high. “And I think the absolute opposite, which is that you should always have protection in your portfolio.” Some benefits that buffer ETFs offer advisors over structured notes and annuities are that they are easier to rebalance within model portfolios, provide access to daily liquidity, and reduce the counterparty risks that exist with put options. others, according to Barsema.

However, the buffer ETFs offer to protect against losses comes at a cost — limiting investors' gains when the market rises. Most of these products have a defined result period of 12 months. If the market posts either a moderate gain or a moderate loss during that time, investors reap the full benefits of these vehicles, industry insiders say. The calculation becomes more complicated when there are large fluctuations in the market, possibly exceeding the downside protection provided or the return limit. The calculation also changes when investors buy or sell from a buffer ETF during the life of the series rather than holding their position for the entire duration, because then the downside protection conditions and return limits set at the beginning of the series no longer apply. and are subject to market conditions. Experts caution that investors could still experience significant losses or miss out on significant gains in those cases.

According to Lan Ahn Tran, manager research analyst with Morningstar, buffer ETFs have proven their model works as intended. However, they may only be a good choice for some investors, and the appropriateness of using them in a portfolio depends on what the investor is trying to achieve. “People may not be fully aware of what they're giving up to get that downside protection,” she said. “It's about the use case, and that's where a little more education is needed.”

People who invest in buffer ETFs sign up for a very narrow range of outcomes, where both the downside and upside they are exposed to are limited, as fund managers of buffer ETFs must limit returns to pay for downside protection, Tran noted. . For investors nearing retirement or those who can't afford even small short-term losses, the protection they get may be a worthwhile sacrifice in exchange for reduced risk, she said. On the other hand, clients with a long-term investment horizon who do not have an immediate need for liquidity may reap more significant benefits from investing in the stock market directly or in traditional ETFs.

While Barsema thinks buffer ETFs can be useful for all types of investors, he advises financial advisors to keep a close eye on how these products perform, especially when using them in model portfolios. He noted that there are now hundreds of different series of buffer ETFs on the market, which adds to the confusion that advisors can feel. “If you are actively rebalancing your model portfolio, which series are you buying and which series are you selling? Advisors don't want to get into the mindset where it's just 'Set it and forget it. This buffer ETF has an indicator. Therefore, I can rebalance whenever I want.' There's a lot more to it because you need to make sure you're rebalancing within the correct series. If you don't, there could be serious consequences.”

For example, if a financial advisor buys a buffer ETF series today that launched in February with a 10% loss hedge and a 10% cap on returns and the underlying index has risen 5% since inception, the client will only have exposure to another 5% of growth, Barsema pointed out. At the same time, if the index gains a total of 2% by the end of the ETF series, the client who started participating in April will end up with a loss because their downside protection will not have started yet.

Many advisers focus on the level of downside protection and upside cap the ETF offers and don't pay enough attention to when the series they're participating in launches, Barsema added. “It's very critical to understand: how many reversals do I have left and when does my defense actually kick in?” he pointed out.

Even investors who participate in a buffer ETF series for its entire duration can end up with an underperforming product if their market timing is bad. Tran offered an example of someone who started participating in an ETF with a 20% buffer in December/January 2021. She noted that that person would end up largely insulated from significant market losses over the subsequent 12-month period . However, “If you bought in the worst case of 2022, maybe July or August, the market wasn't really going any lower. If you were to buy a fund with 20% protection at that point, until July or August 2023, you would simply miss out on the gains that the market gave back over those 12 months.”

Morningstar recently conducted a study that looked at the returns of the S&P 500 on a rolling 12-month basis from the index's inception in 1928 to 2023. The study found that within those time frames, the index experienced a loss of approximately zero to 15% 15% of the time, lost more than 10% another 17% of the time, and posted a gain of more than 15% about 30% of the time. The results show that buffer ETFs won't completely insulate investors from losses, but they can often limit their upside.

Meanwhile, Morningstar found some additional costs to invest in buffer ETFs compared to regular ETFs. Their fees are about 70% to 80% higher. Investors can forgo any dividends from the underlying stocks with many buffer ETFs, unlike the S&P 500. Annual returns on them range between 1.5% and 2%, according to Morningstar. For these reasons, Tran said buffer ETFs may be best suited for nervous investors who have trouble staying in the stock market when it becomes volatile and those who need easy access to liquidity.

“My recommendation for people who have a longer horizon is to stay invested in equity for the long term. For investors with 10-15 year horizons, the index lost 20% in 2022 and by January this year, it was already back to where it was in December 2021. If you are able to stay invested, I would suggest that you invest in buy and hold rather than trying to get too involved with the equity sleeve.



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