Buffered ETFs are a relatively new innovation in the world of exchange-traded funds (ETFs) designed to provide investors with downside protection while still allowing for potential growth. These ETFs are structured to limit investors' exposure to losses within a certain range while offering the opportunity to participate in the upside potential of a particular market or asset class. Here's how they typically work:
Buffer Zone: Buffered ETFs provide investors with a predefined buffer zone within which their investment is protected from losses. For example, a buffered ETF may offer a buffer of 10%, meaning that investors are protected from the first 10% of losses in the underlying index or asset.
Participation Rate/Performance Cap: In exchange for this downside protection, investors typically accept a lower return rate for gains of the underlying asset. There are two ways that buffered ETF’s will express this: participation rate, or performance cap. Both determine how much of the upside investors can capture. For instance, if the underlying index or asset increases by 10% and the participation rate is 70%, investors in the buffered ETF would capture only 70% of that gain, or 7%. Likewise, if the underlying index or asset increases by 10% and the performance cap is 7%, the investor would “cap out” at 7% of the gains experienced by the asset, no matter how high they go. Importantly, the rate of return, be it participation rate or performance cap, is calculated based on the volatility of the asset being measured. The higher the volatility of the underlying asset, the more gains one is subject to missing out on.
Reset Periods: Buffered ETFs often have reset periods, which are intervals at which the downside buffer is recalibrated. This means that the level of protection may change over time, depending on market conditions and the specific terms of the ETF. Selling at times in between buffer reset periods will void the buffer, providing a return in line with the market value of the buffered security.
Potential Return Scenarios: The following graph shows four scenarios for a buffered ETF. The graph assumes a buffer of 10%, and a performance cap of 7%.
Source: First Trust – How Does a Target Outcome Buffer ETF Work?
NOTE: This information is strictly for illustrative and educational purposes and is subject to change. This is not meant as a guarantee of any future result or experience.
Potential Use Cases: The obvious use case for buffered ETFs is in periods of high expected volatility in markets, as a means of reducing potential losses. An area in which Buffered ETFs may also see feasibility is as a replacement for a portion of one’s core asset allocation. Some investors are beginning to use Buffered ETFs as part of their core allocation, as it has the potential to reduce volatility in a part of the portfolio that is not meant to create massive returns. This can free up investors up to take larger risks in the alpha-generating, high-return areas of their portfolio instead, without worry of taking a large loss from their core allocation.
Costs and Fees: Like other ETFs, buffer ETFs come with management fees and other expenses. These costs can vary depending on the provider and the complexity of the product. Investors should carefully consider these costs when evaluating the suitability of buffer ETFs for their investment objectives.
Options: A large building block in the structure of Buffered ETFs are options, and they are employed as follows:
- Selling Call Options: When a fund does this, it generates income, while simultaneously setting an “upside cap”, or a cap on how much the fund can earn in a given period.
- Buying Put Options: This is done to create a safety net; if the underlying asset sees losses, there's early protection for the investor.
- Selling Put Options: This helps cover the cost of the above safety net, but it also means that if the safety net runs out and the underlying asset continues to lose value, the ETF’s value will drop too.
Conclusion: Buffer ETFs have the potential protect investors’ money in times of increased volatility. As with any investment, it's crucial for investors to conduct thorough research and consider their risk tolerance, investment goals, and time horizon before investing in buffer ETFs. Consulting with a financial advisor can also provide valuable guidance in determining whether these products align with an investor's overall strategy.
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