Buffered ETFs Pros and Cons: A Comprehensive Guide

Buffered ETFs offer a unique investment strategy that can help protect your portfolio from market downturns. They work by allocating a portion of your investment to a fund that tracks a specific asset class, such as stocks or bonds, and another portion to a fund that tracks a different asset class, such as cash or a benchmark index.

This dual-tracking approach helps to reduce the overall volatility of your investment, making it a more stable option for those who want to minimize their risk. By diversifying your investment across different asset classes, you can potentially reduce your exposure to market fluctuations.

In the long run, buffered ETFs can be a good choice for investors who want to balance their risk and reward.

Buffered ETFs are a type of exchange-traded fund that protects your investment from significant losses by using a buffer or a cap to limit the maximum decline.

They work by investing in a combination of a traditional ETF and a derivatives contract that provides a floor or a cap on potential losses. This means you won't lose more than a certain percentage of your investment.

The buffer is typically set at a specific percentage, such as 10% or 20%, which means your investment won't decline by more than that amount. For example, if you invest in a 10% buffered ETF and the market goes down by 15%, you'll still be down 10%.

The buffer is usually achieved through the use of options or other derivatives, which can be complex and may not be suitable for all investors.

Buffered ETFs can be a cost-effective option for investors, especially when compared to traditional mutual funds. One of the main advantages of buffered ETFs is their lower fees.

The variety of buffered ETFs available in the market is both a good and a bad thing. On the positive side, there are variants to fit any risk profile, from very conservative to very aggressive. This means that investors can find an ETF that matches their specific buffer needs.

However, this also means that investors must do their due diligence and understand the trade-offs between upside potential and downside risks.

Buffered ETFs carry drawbacks, including the risk of not enjoying gains beyond a certain point if the market is up a lot. If markets sell off too much, the buffered ETF is exposed to open-ended losses.

The specific returns advertised by these products are often not realized, as they rely on investment on a specific date and holding the investment through expiration. Investors who join after the launch or leave the series before the end of the period may receive far different returns.

Buffered ETFs charge higher fees, with an average expense ratio of 0.77%, compared to the typical 0.59% fee for actively managed diversified U.S. stock ETFs.

One of the downsides of buffered ETFs is that they can limit diversification, especially when it comes to smaller companies. This is because many ETFs track large-cap indices, which may not include mid- and small-cap stocks.

For example, we know that some sectors or foreign stocks may only have a narrow group of equities in the market index, limiting ETF investors to large-cap stocks. This can leave potential growth opportunities out of reach.

To illustrate this point, let's consider that since 1957, calendar year returns for the S&P 500 have been positive 45 times, and negative 18 times. This highlights the importance of diversification in reducing risk.

Here's a table showing the potential impact of limited diversification:

As you can see, mid-cap and small-cap ETFs may offer more diversification than large-cap ETFs, but they may also come with higher risks. It's essential to weigh these risks and benefits carefully before making a decision.

Dividend-paying ETFs often have lower yields compared to individual high-yielding stocks. This is because ETFs track a broader market, which averages out the yield to be lower.

If an investor is willing to take on the risk, owning individual stocks can result in much higher dividend yields.

The cost of buffered ETFs is a significant drawback, with an average expense ratio of 0.77%, which is higher than the typical 0.59% fee for actively managed diversified U.S. stock ETFs.

Time is of the essence when investing in buffered ETFs. You need to buy these funds within a week of the start of its 12-month stretch, when the fund rebalances.

If you don't buy at the start of the outcome period, the buffer and cap will shift depending on the broad market's moves and the fund's net asset value each day.

You can get out of a buffered ETF at any point, but it's not a time deposit. The outcome period of the April series of Innovator S&P 500 Buffer ETF, for example, is April 1, 2024, to March 31, 2025.

At the end of the 12-month period, you may want to review the new outcome parameters for the coming year, as the buffer and cap will change.

Here are some key things to keep in mind when investing in buffered ETFs:

Buffered ETFs are a type of investment that can help reduce the impact of volatility by protecting against significant market events.

They work by buying call options, puts, and selling puts to create a buffer against losses, with common buffer levels being 10% and 20%.

This means that if the market declines by 10% or 20%, the ETF will absorb the loss, allowing the investor to maintain their exposure with a defined outcome.

In fact, since 1957, calendar year returns for the S&P 500 have been positive 45 times, and negative 18 times, with negative returns exceeding 10% nine times, and 20% three times.

Buffered ETFs can be a great investment for long-term investors and those with shorter-term time horizons, especially for beginning investors who may not have the time, effort, and experience to research individual stocks.

Here's a summary of the benefits of buffered ETFs:

Trading buffered ETFs is a lot like trading individual stocks, but with some key advantages. You can buy and sell them throughout the trading day, and their prices are updated in real-time.

The prices of buffered ETFs are determined by the market, just like individual stocks. This means there's always a buyer and a seller, and the difference between the price you can buy and sell is relatively small.

One of the benefits of trading buffered ETFs like stocks is that they can be purchased on margin and sold short. This gives you more flexibility in your investment strategy.

Here are some key similarities between trading buffered ETFs and trading individual stocks:

The liquidity of the most popular buffered ETFs is actually higher than that of many individual stocks. This means you can easily buy and sell them without affecting the price.

Investing in Buffered ETFs can be a great option for long-term investors.

They can also be valuable to those with shorter-term time horizons, as they offer a more stable investment option.

For beginning investors, Buffered ETFs can be especially beneficial, as they don't require the time, effort, and experience needed to research individual stocks.

Investing in Buffered ETFs may be more cost-effective than buying a diversified selection of individual stocks, which can be a significant advantage for those on a budget.

You can buy buffered ETFs at any point in time, either at the start date or any day after. This means your purchase price is especially important with buffered ETFs.

Each buffered ETF has a set share price on its first day of being issued, which will move as it tracks the underlying index.

The stated cap and buffer levels apply only for investors who invest at the start of the outcome period and hold for the entire outcome period.

If you buy intra-period after the launch date and hold for the remainder of the outcome period, remaining cap and remaining buffer levels at the purchase price apply.

For investors who sell intra-period before the outcome date, cap and buffer levels do not apply. Returns will be based on market value of the buffered ETF.

Here's a quick rundown of the three variables to be aware of when purchasing a buffered ETF:

These variables are dependent on the relationship between the index and ETF if purchased after the start date, and having real-time data on them is important when making a purchase.

ETF Investment Strategies can be complex, but understanding the basics can help you make informed decisions. A buffered ETF typically has four layers, including buying a call option, purchasing puts, selling puts, and selling a call option to cap returns.

The rate of return for a buffered ETF depends on two factors: the underlying index return and the terms of the FLEX Options at the start of the outcome period. This means that the buffer level and upside cap will move real-time intra-period depending on market performance.

Common downside buffer levels for ETFs are 10% and 20%, providing a cushion against declines in the reference index. The upside cap, on the other hand, is determined at the buffered ETF start date and depends on the options market at the time.

Investors can use buffered ETFs to help reduce volatility, diversify traditional allocation, or shift cash off the sidelines. By repositioning a portion of domestic equity exposure, investors can potentially reduce downside volatility while maintaining a level of equity upside.

Here's a summary of the benefits of using buffered ETFs:

It's essential to understand that buffered ETFs may not be suitable for all investors, and it's crucial to do your due diligence and research before investing in a particular strategy.

Buffered outcome ETFs have some unique risks that investors should be aware of. If the market is up a lot, the ETF will not enjoy gains beyond a certain point, which is an opportunity cost.

One of the biggest risks is exposure to open-ended losses if markets sell off too much. This is a very real risk to capital, and it's essential to consider it before investing.

The specific returns advertised by these products are often not realized by investors who join after the launch or leave the series before the end of the period. This means the structured returns are only there for investors who invest on a particular date and then stay the entire time.

Investors need to consider what to do after the outcome period ends and the potential market conditions at that time. This is crucial because the risk mitigation zones can be structured, but the corresponding upside cap may be different over time.

A vast number of variations of buffered products have been released over the last few years, which can be both a good thing and a bad thing. On the positive side, there are variants to fit just about any risk profile, from very conservative to very aggressive.

However, this means investors must do their due diligence and understand the trade-offs between upside potential and downside risks before investing in a particular strategy.

In conclusion, buffered ETFs offer a unique way to invest in the markets while minimizing potential losses.

Buffered ETFs can provide a higher return than traditional ETFs, with some examples showing returns of up to 7% in a year.

One key advantage of buffered ETFs is that they can help investors avoid significant losses in a downturn, as seen in the example of the 2020 pandemic, where a buffered ETF with a 30% buffer maintained a positive return.

Investors should carefully consider their risk tolerance and investment goals before investing in a buffered ETF, as they often come with higher fees than traditional ETFs.

ETFs can make up a portion of your portfolio or be the only type of security you invest with.

ETFs have many advantages, especially compared to managed funds like mutual funds.

In contrast to managed funds, ETFs can be compared to broader investments or even entire indexes in their price movements.

Certain ETFs may have limitations when it comes to diversification and dividends.

ETFs that live by an index can also die by an index, since no nimble manager is involved to shield performance from a downward move.

The tax implications of ETFs must be considered when deciding if they are the right investment for you.

As we move forward, market volatility is driving demand for outcome-based ETFs, which can provide a more stable investment experience.

This shift is largely due to the growing recognition of the benefits of buffered ETFs, which can offer the best of both worlds: market participation with downside risk mitigation.

With the increasing popularity of buffered ETFs, it's essential to carefully consider the entry point to maximize their potential.

Here are some key factors to keep in mind when evaluating buffered ETFs: