No one likes losses or even the idea of losing money. It is that fear of volatility that keeps many investors up at night. This is particularly true for older investors and those who are closer to retirement. They simply don’t have the time at that point to make up for any losses before they start pulling from their nest eggs. It’s a tough spot to be in, considering longer lifespans might require more exposure to equities.
But, innovation breeds new tools.
For investors concerned about these risks, active ETF innovation has created new defined outcome ETFs, or buffer ETFs. With guarantees in place to generate a steady return, investors worried about risk now have a way to boost returns for the long haul without worrying about losses. And with a big-time ETF play now entering the market, buffer ETFs could be a serious portfolio contender.
The Rise of Buffer ETFs
Despite the fact that 2022 is well in the rearview mirror, the year and its poor market returns are still having effects on portfolios and investor psychology. Surging inflation and interest rates sent stocks, bonds and alternative asset classes like real estate down in a big way. Hardly any asset class was spared. For many investors, those losses stung, and the rules of diversification were thrown out the window.
For those in or near retirement, this was a huge blow to their portfolios and gave them plenty of sleepless nights. However, Wall Street has come up with a solution to the nagging concerns — the rise of active ETFs has led to the rise of defined outcome or so-called buffer ETFs.
Buffer ETFs are actively managed. But instead of buying bonds or stocks, they use derivatives contracts to gain the desired outcome. Managers will buy options contracts to track the performance of their underlying indexes and, simultaneously, sell the call options tied to the same index. This creates a price floor for the fund that kicks in when the market has a drawdown below this amount. At the same time, the options contracts create a cap on gains. The basic idea is that investors can limit or remove losses and have a planned outcome for gains.
Defined outcome ETFs are structured in two ways. The most common way is funds with upside caps, which buffer a range of losses such as 10%, but then cap returns beyond a certain point such as 15%. The second way is funds with a downside floor, which provide maximum insulation against losses but are more restrictive on their upside caps, typically limiting to just 5% to 7% of the market’s gains. This structure offers the most downside protection.
For investors, this is a powerful tool and provides near guarantees when it comes to returns. They know this investment can produce gains or losses of X% for a certain period of time — and they work even better than holding cash.
For example, an investor holding Warren Buffett’s preferred asset mix — an 80/20 stock/T-bill mix that realizes a 20% market loss — would see their portfolio drop by 15.5%. However, if they held a buffer ETF using the funds-with-upside-caps method would see a loss of just 5%. Moreover, if the market rose by 20%, the mix would produce a 16.5% return. The buffer ETF would rise by the full 20%. 1
Surge in Popularity
With the wounds from 2022 still fresh, investors have been drawn to these new defined outcome ETFs in spades. The first buffer ETF launched in 2018, but it wasn’t until recently that new launches picked up pace. We are looking at a 70% growth rate in new defined outcome funds and assets in just three years.
This chart from Morningstar shows the rapid climb of defined outcome ETF assets and the number of funds on the market. Today, more than $225 billion sits in these funds.
Source: Morningstar
And the market keeps getting bigger.
Massive ETF issuer BlackRock is the latest to pile on the trend, launching three funds that provide 5%, 20% and a 100% buffer on losses. Fidelity and J.P. Morgan have followed, and there are numerous filings for new buffer ETFs on the horizon.
The popularity for defined outcome ETFs comes as they appear to be a superior structure to another historical way investors have buffered their portfolios — annuities.
Indexed annuities function in much the same way as buffer ETFs: providing a floor for losses while capping gains. However, using ETFs to accomplish the same goal has unique wins. One of the biggest is costs. Even the best annuities tend to be expensive with fees, sales charges and other costs. Most buffer ETFs cost less 0.75% in total expenses and can be purchased commission free.
Secondly, annuities tend to be hard to get out of because of surrender charges, lock-up periods and fees. With ETFs, if you don’t like your picks or want to change your strategy, a simple click of the mouse and they’re gone from your portfolio.
Getting That Defined Outcome
Because of their advantages, it’s easy to see why defined outcome ETFs have become so popular in recent years and why they continue to find a place in many portfolios. The question is, should they belong in yours?
The answer could use an asterisk.
Because of the upside caps on these funds, they can’t necessarily serve as your only equity holdings. Many advisors and industry pundits warn that investors may not get enough gains over the long haul. But as a way to secure a portion of your portfolio, they make perfect sense. Also keep in mind, buffer ETFs aren’t an income solution as they don’t pay dividends.
Another thing to think about is that several buffered ETFs are tied to a certain month and provide protection up to that month. Buying and holding a defined outcome ETF off schedule will lose some of the defined benefit, while selling will provide less of the upside potential.
Buffer ETFs
These actively managed funds are just some of the buffered ETFs available with several issuers offering different monthly vintages. They are sorted by their YTD total return, which ranges from 8.2% to 9.8%. They have expense ratios of 0.74% to 1.05% and assets under management of $144M to $1.21B. None of them pay a dividend currently.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| PJAN | Innovator U.S. Equity Power Buffer ETF - January | $1.21B | 9.8% | 0% | 0.79% | ETF | Yes |
| BUFD | FT Vest Laddered Deep Buffer ETF | $879M | 8.5% | 0% | 1.05% | ETF | Yes |
| JULW | AllianzIM U.S. Large Cap Buffer20 Jul ETF | $144M | 8.2% | 0% | 0.74% | ETF | Yes |
Overall, defined outcome ETFs continue to surge in popularity — and it’s easy to see why. Offering downside protection while still capturing the upside, many investors are turning to these products to help their portfolios grow … and still sleeping well at night. As volatility and downside potential grows, so should the market for these active ETFs.
Bottom Line
Rising volatility and the losses from 2022 are still fresh wounds in many investors’ minds. To that end, buffer or defined outcome ETFs have surged in popularity. Offering downside protection in exchange for capped upside, these active ETFs can be a great way to hedge a portion of your portfolio and reduce a portfolio’s overall risk.
1 AB (December 2022). Defined Outcome ETFs: Pulling Double Duty