Downside Limit on Buffered ETFs: A Comprehensive Guide

A downside limit on buffered ETFs is a type of protection that helps shield your investments from significant losses.

The downside limit is typically expressed as a percentage, such as 20% or 30%, which means the fund's value will not fall below that percentage of the original investment.

You can think of it like a safety net that kicks in when the market starts to decline, preventing you from losing too much money.

For example, if you invest $10,000 in a 20% buffered ETF and the market drops 30%, the fund will still be worth $8,000, which is 80% of the original investment.

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Buffered ETFs are a type of investment that's not your typical stock or bond fund, but rather an alternative investment that offers a certain level of protection against losses.

They come in a variety of risk-reward combinations, with the majority offering a certain cushion on losses over a 12-month stretch in exchange for a give-back on gains.

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The Innovator S&P 500 Buffer ETF April (BAPR) aims to track the SPDR S&P 500 ETF Trust (SPY) and offers a 9% buffer against losses for investors who bought shares at the start of April 2024.

The downside protection is fixed, depending on the strategy, but usually ranges between 10% and 20%, and the bigger the down-market cushion, the smaller the potential gain.

Investors who bought shares in BAPR at the start of April 2024 will suffer a 6% loss if SPY declines, say, 15% by the end of the 12-month period ending in March 2025.

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Buffered ETFs are not your typical stock or bond funds, but rather a type of alternative investment that requires a certain level of understanding to navigate.

They offer a unique risk-reward combination, with most providing a cushion on losses over a 12-month stretch in exchange for a give-back on gains.

Ryan Issakainen, First Trust's ETF strategist, notes that investors need to have the right expectations to make the most of these funds.

These funds come in a variety of risk-reward combinations, allowing you to choose the right fit for your investment goals.

Some buffered ETFs allow you to capture more of the stock market's gains, while others focus on downside protection.

Graham Day, chief investment officer at Innovator ETFs, says there's a super-wide array of ways to use these products, from complementing a stock portfolio to serving as bond alternatives.

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ETFs, or exchange-traded funds, are a type of investment that allows you to diversify your portfolio with a single security. Most buffered ETFs are linked to the S&P 500 Index.

These funds typically have a 12-month outcome period, which defines the range of returns possible over the period. The downside protection is usually fixed, depending on the strategy, but often ranges between 10% and 20%.

The protection offered by these ETFs can be substantial, like the 9% buffer against losses offered by the BAPR ETF. This means if the S&P 500 drops up to 9% over the 12-month period, shareholders lose nothing.

The potential gains of these ETFs are also capped, with the Innovator S&P 500 Buffer April ETF topping out at 18.3% returns over the 12-month period.

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ETFs can be a great investment tool, but like any investment, they come with their own set of pitfalls.

High fees can eat into your returns, so it's essential to choose an ETF with low or no fees.

Some ETFs may not track their underlying index perfectly, which can lead to tracking errors that negatively impact your investment.

Investors should be aware that ETFs can be subject to market volatility, just like individual stocks.

ETFs can be traded throughout the day, but this can also lead to high trading costs, especially for frequent traders.

Investing in a single ETF can expose you to a concentrated risk, so it's crucial to diversify your portfolio.

In addition, some ETFs may hold a large amount of cash or other securities that can affect their performance.

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ETFs buy a put option to protect against losses on the underlying security and sell a call option to finance the purchase. This combination provides a performance floor and sets a ceiling.

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The put option gives you downside protection, while the call option limits your upside potential. Both options have the same expiration date and typically use a popular index like the S&P 500 as the underlying benchmark.

A buffer ETF, like one that follows the S&P with a 20% buffer, will not let you lose more than 10% of your investment if the market dips 30%. However, you'll also be capped at a 20% gain if the market surges 75%.

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ETFs, or exchange-traded funds, are a type of investment that tracks an underlying asset, like a stock market index. They're designed to provide a specific return profile over a set period, known as the outcome period.

A buffer fund, also called a defined-outcome fund, is a type of ETF that aims to protect against a certain amount of market decline, known as the buffer level. This could be 10%, 15%, or some other figure, depending on the specific fund. For example, if the buffer level is set at 10% and the underlying asset drops 35%, the fund would only protect against the first 10% of the loss.

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The performance of a buffer fund is tied to the underlying asset, and its value at the end of the outcome period depends on the asset's performance. If the underlying asset falls by an amount within the buffer level, the fund will absorb that loss and be worth what it was at the start of the outcome period. You wouldn't make a loss on the investment, other than the fund's fees.

Here's a breakdown of how a buffer ETF's payoff profile works:

The tradeoff is that you're giving up some potential upside for the protection. For example, if the cap is 20%, that's the max you can earn from the ETF, even if the underlying asset surges 75% in the same time period.

The payoff profile of a hypothetical 100% downside protection ETF is a crucial aspect to consider. The upside cap typically equals the T-bill rate for the duration of the options, plus a spread. As interest rates come down, the cap will also decrease and might lose its appeal.

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The current cap for 100% protection ETFs with an outcome period between July 2024 and July 2025 is around 10%, or nearly double the one-year risk-free rate. This means investors can miss out on substantial stock market gains if they opt for this type of ETF.

Principal protection is not guaranteed the same way a CD would be, nor is the stated cap always achieved. In fact, investors can receive a different payout structure if they buy and sell the ETF outside of the stated outcome period.

Investors should consider the time-value of options and volatility when evaluating the payoff profile of a hypothetical 100% downside protection ETF. The options' values will converge with their defined outcome as they approach expiration, but their prices can deviate during the period.

The payoff profile of a hypothetical 100% downside protection ETF is a complex aspect to navigate, but understanding the key factors can help investors make informed decisions.

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Investing in ETFs can be a great way to diversify your portfolio, with over 7,000 options available, offering exposure to various asset classes, sectors, and geographic regions.

Many investors choose ETFs for their flexibility and ease of use, allowing them to trade throughout the day and often with lower fees than actively managed funds.

ETFs also offer transparency, with their holdings publicly disclosed daily.

Investing in funds can be a good option if you're a conservative investor and willing to sacrifice some potential returns in exchange for protection against losses.

You might also consider funds if you're nearing retirement and prioritizing preserving capital. Buffer funds can provide stability during times of market volatility.

They're not exactly cheap, though - Innovator Capital Management's funds have an expense ratio of 0.79%, which is higher than the underlying ETF's 0.09%.

It's also essential to consider the remaining cap and buffer levels, which are highest at the start of the outcome period. You want to invest in funds with substantial remaining cap and buffer amounts.

If you invest in a buffer fund, you won't perfectly track the underlying asset when the options are still far from expiration. This means the fund won't capture upside immediately if there's a big rally in the underlying asset.

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To get started with investing in ETFs, you'll need to choose a brokerage account. This can be done through a traditional online broker or a robo-advisor.

You can also consider opening a taxable brokerage account for more control over your investments.

For beginners, it's a good idea to start with a tax-advantaged account, such as a Roth IRA or a traditional IRA.

This will allow you to contribute pre-tax dollars or after-tax dollars, respectively, and potentially reduce your tax liability.

When selecting an ETF, look for one that tracks a broad market index, such as the S&P 500.

This will give you exposure to a wide range of stocks and help you diversify your portfolio.

You can also consider ETFs that track specific sectors or industries, such as technology or healthcare.

These can be a good way to gain exposure to a particular area of the market.

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Innovator Capital Management's Latest ETF Offering is a great example of how to implement a downside limit on buffered ETFs. Their ETFs offer a range of upside participation, from 50% to 100% of the S&P 500's returns.

One of their ETFs, the Innovator S&P 500 Buffer ETF (CBOE: BFIN), has a 15% buffer on the downside, which means it will not fall below -15% of the S&P 500's returns. This can provide some peace of mind for investors who want to participate in the upside of the market while limiting their potential losses.

Innovator Capital Management has also developed a range of ETFs with different buffer levels, from 5% to 20% on the downside. These ETFs are designed to provide investors with a more tailored approach to managing risk.

Their ETFs are listed on the CBOE and are designed to be traded throughout the day, allowing investors to buy and sell them as needed. This flexibility can be beneficial for investors who want to adjust their portfolios frequently.

The fees associated with Innovator Capital Management's ETFs are relatively low, ranging from 0.79% to 0.95% per year. This can be a more cost-effective option for investors compared to other types of investment products.

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Buffered ETFs can offer a level of protection against losses, but it's essential to understand how they work and what to expect.

The first thing to consider is the cost. Buffer ETFs are not cheap, with an expense ratio of 0.79% for Innovator Capital Management's funds tied to the SPDR S&P 500 ETF, which is considerably higher than the expense ratio of the underlying ETF.

To get the exact payoff profile promised by a buffer fund, you have to hold it from the first day of the outcome period until the last day. This means you need to be committed to holding onto the fund for the entire period.

A zero-strike, or deep-in-the-money, call option is the most expensive part of the formula, requiring 98% of your investment. This is the costliest part of the equation.

To fully protect your investment, you need a combination of options, including a zero-strike call option and an at-the-money put. However, these costs add up to 102% of your initial investment, which is impossible.

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Here's a breakdown of the costs involved in fully protecting your investment:

In theory, if the S&P has a catastrophic crash, your investment would not be lost, but it might not be as liquid. Your put options package would be flat, and it would be a matter of whether you can sell it to someone.