If it’s true that the psychological pain of losing money is twice as great as the joy you feel when you make a gain, then there’s an exchange-traded fund for that. A new kind of ETF, called a defined-outcome or buffered ETF, caps your losses in the stock market in exchange for giving up some of your potential gains.
And they’re growing in popularity: The first defined-outcome ETF was launched in 2018. There are now about 270 funds with total assets of $47 billion.
Interest in these ETFs has grown after both stocks and bonds posted dismal returns in 2022, as investors looked for ways to build some protection into their portfolios. But buffered ETFs are also attractive to risk-averse investors who want to maintain exposure to the stock market.
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Rumor has it that recent and soon-to-be retirees are interested, with money that could last them 30 years. “Without equity-like returns, you can’t sustain your standard of living for that long,” says Matt Collins, head of ETFs at PGIM Investments. “Some people are willing to take some risk to get those opportunities, but they don’t want to take a lot of risk. And they’re a little more comfortable investing in big U.S. stocks if they can deliver a narrower range of outcomes.”
Buffer strategies are not new: Such approaches have existed for years in mutual funds, annuities and other products sold by insurance companies. But the ETF version is available to all investors. Innovator and First Trust were the first to offer buffer ETFs, while Allianz IM, Pacer and TrueShares entered the market in 2020 and 2021. More recent entrants include iShares, PGIM Investments and Fidelity.
The problem is, these actively managed strategies require a lot of explaining. They aren’t your typical stock or bond funds. In fact, they’re somewhere in between, more like alternative investments. “Investors need to reach a certain level of understanding to have the right expectations,” says Ryan Isakainen, ETF strategist at First Trust. That’s one reason why the majority of buyers of defined-outcome ETFs these days aren’t individual investors, but financial advisors buying ETFs on behalf of their clients. And that may be a good thing.
Buffered ETFs offer a variety of risk/reward combinations. Most offer a fixed cushion against losses over a 12-month period, but will return on gains. But others have tweaked the formula. Some allow you to capture more of the stock market’s gains, while others focus more on protecting against downside. A new addition is an ETF that hedges against stock losses and guarantees dividend-like payments, but that’s a story for another time (stay tuned).
“There are so many different ways these products can be used,” says Graham Day, chief investment officer at Innovator ETFs. “They can be used as a complement to an equity portfolio, as a replacement for bonds, or as a sleeve of alternative investments that can zig-zag when other parts of a portfolio move.”
In the next few paragraphs, we’ll explain how these funds generally work, walk you through the wide variety of strategies available, and discuss the pros and cons of each. We’re focusing on ETFs for equity investors here; the glossary on the right will help you understand the terminology. Returns and data are through April 30th.
How do ETFs work?
Most buffered ETFs track the S&P 500 index. Fund managers define how much protection they want on downside (buffer) and set a ceiling on upside returns (cap) by investing in options contracts, which allow them to buy and sell shares of the S&P 500 ETF at a certain price by a certain date.
The most common type of buffered ETF has an outcome period of 12 months. The range of possible returns during this period is determined by the options contracts held by the fund. At the end of the one-year period, the ETF rebalances by purchasing new options to secure the promised buffer, resetting the cap for the next 12 months.
Downside protection is usually fixed depending on the strategy, but typically ranges from 10% to 20%. How much upside gain you give up depends in part on the amount of protection the fund offers. The larger the downmarket cushion, the smaller the potential gain. Market volatility and interest rates also affect how high or low your gain cap can be.
Let’s look at an example: Innovator S&P 500 Buffer ETF April (symbol BAPR) aims to track the SPDR S&P 500 ETF Trust (SPY).
Investors who bought BAPR shares in early April 2024 have a 9% buffer against losses. This means that if SPY falls by up to 9% in the 12 months to March 2025, the shareholder will not lose money. However, losses beyond 9% are not protected. If SPY falls by, say, 15% by the end of the 12 months to March 2025, a shareholder who bought BAPR in early April 2024 would suffer a 6% loss.
Meanwhile, the Innovator S&P 500 Buffer April ETF has a 12-month potential return of 18.3%, and any gains above that are forfeited. “These products deliver on what they promise,” Innovator’s Day says. “That level of predictability — knowing what you’re going to get — is very powerful.” In the period that just ended in March, investors gained 19.3% for the year. By comparison, the S&P 500 gained 29.9%.
The pitfalls of buffered ETFs
Naturally, these strategies come with some caveats, one of which is cost: The average expense ratio for buffered ETFs is 0.77%, which is higher than the typical 0.59% fee for actively managed diversified U.S. equity ETFs.
Timing of purchases is also important: It’s best to buy these funds within a week of the start of a 12-month period, when the funds are just about to rebalance — for example, buy a July-dated buffered ETF in late June or early July.
And plan to hold the ETF for at least a year. For investors who don’t buy at the beginning of the outcome period, the buffer and limit change daily depending on the overall market movement and the fund’s net asset value. That’s why these strategies are published in monthly format. Fund companies want to give investors the option to buy throughout the year. That said, these funds are not fixed deposits. They can be withdrawn at any time.
Finally, the buffers and caps for a particular ETF apply for the entire outcome period of that ETF. The Innovator S&P 500 Buffer ETF’s April Series outcome period runs from April 1, 2024 to March 31, 2025. If you buy and hold the fund, it doesn’t matter what happens in between. What matters is where the market is at the end of the outcome period.
That makes an investment in a buffered ETF similar to a one-year bond that you hold to maturity.“What they say they’re going to deliver in a fixed-outcome ETF in January doesn’t happen until Dec. 31, 12 months from now,” PGIM’s Collins says.“And it’s a slow effort.”
At the end of the 12-month period, when the fund rebalances by purchasing a new set of options, you may want to consider what to do next with the money in the fund. You can also do nothing, in which case the assets will remain in the fund and automatically roll over to the next one-year period. However, it’s a good idea to review the new outcome parameters for the coming year. “Continuous monitoring of annual limits is something you’ll want to stay on top of,” says Collins.
Choose from a variety of ETF options
The S&P 500 isn’t the only index that gets buffered: Innovator and First Trust offer defined outcome ETFs that track the Nasdaq index, the MSCI EAFE (tracking developed foreign stocks), the MSCI Emerging Markets index and the Russell 2000 (a benchmark for small-company stocks). In general, these ETFs function similarly to a 12-month defined outcome fund that tracks the S&P 500.
But other twists on the defined outcome formula are also worth noting.
Further upwards. Some funds don’t cap their potential returns, which may appeal to investors more interested in growth than downside risk protection. For example, in exchange for accepting a percentage point limit on their potential returns, investors in the TrueShares Structured Outcome ETF can expect to earn about 75% to 80% of the S&P 500’s price return over any 12-month period, no matter how much the index rises.
For example, the TrueShares Structured Outcome January ETF (JANZ), which has a 12-month outcome period beginning in early January, returned 18.9% in 2023, equivalent to 78% of the S&P 500’s 24.2% price return.“Over the long term, missing out on the upside can be just as damaging to a portfolio as the downside,” said Michael Lucas, CEO of Trumark Investments, which manages the TrueShares ETF.The TrueShares Structured Outcome ETF aims to offer 10% downside protection.
Industry insiders call these strategies “uncapped” fixed-outcome ETFs. In Allianz IM’s uncapped version, investors give up the first 3 percent gain but pocket any gains beyond that — a 1 percent gain if the broader market rises 4 percent, but a 47 percent gain if the market surges 50 percent. The company’s first uncapped fixed-outcome ETF, Allianz IM US Equity Buffer 15 Uncapped Upreatio (ARLU), launched in March and offers a 15 percent buffer against losses.
Large cushion. Nearly all buffered ETFs offer some degree of downside protection, but most don’t fully protect against severe bear markets. There are exceptions, but they are relatively new and have little track record.
One exception is a family of funds called Innovator Equity Defined Protection ETFs, which aim to provide 100% protection against losses before fees and expenses for two years. Of course, the price of that protection is lower potential returns. The oldest of these funds, Innovator Equity Defined Protection ETF 2 Year to July (TJUL), will launch in July 2023, and the maximum return investors can expect over two years is a cumulative 16.6% before fees.
Allianz IM has shortened its outcome period, which can be an advantage in a rising market. For example, Allianz IM US Large Cap 6 Month Floor 5 April/October (FLAO) limits losses to 5% or less, but rebalances every 6 months. Gains are still capped. For investors who bought the April/October fund when it resets in early April, gains will be capped at 8.81%. Allianz IM’s two uncapped funds were launched this year, so they have little track record. We’re keeping an eye on these.
All in one. Some firms are bundling ETFs into one fund, with clear monthly results, but the end result can be less predictable. “A fund-of-funds ETF doesn’t have a clear performance, but its underlying holdings do,” First Trust’s Isakainen says. “You end up with something a little different, but ultimately ETFs are less volatile than the overall market, and that’s the way it should be.”
For example, First Trust’s FT Best Fund of Buffers ETF (BUFR) holds 12 clearly-performing ETFs equally over a 12-month holding period from January to December. All underlying funds provide a 10% buffer against losses in the S&P 500. Gain caps range from 15.7% to 18.9%.
The Pacer Swan SOS Fund of Funds ETF (PSFF) takes a more proactive approach, dynamically buying and selling monthly funds depending on market conditions. “If the market rises significantly, the manager may sell the monthly series and move into a new series, increasing the cap and creating a larger buffer,” says Sean O’Hara, president of Pacer ETFs.
Our bottom line: These funds are solid low-volatility equity strategies. When the S&P 500 fell 18.1% in 2022, the buffer ETF’s First Trust Fund fell 7.7%, while the Pacer Fund fell just 4.0%. But if you’re looking for predictable results, a fund of funds may not be the best option.
Note: This item first appeared in Kiplinger Personal Finance Magazine, a monthly publication of advice and guidance you can trust. Subscribe to help you make more money and keep more of what you earn. here.
