Financial innovation in the ETF space continues to open new possibilities for investors. A case in point is the invention of buffered ETFs. They have been around since 2018 but have started to see stronger inflows of capital in recent quarters. Buffered ETFs offer some of the upside potential of a base market index (like the S&P 500) while limiting the downside potential, over a specified holding period (typically one year).
Who uses buffered ETFs?
A buffered ETF, which can also go by monikers such as “defined outcome,” “buffered outcome,” or “target outcome” ETF, is an investment tool made with more risk-averse investors in mind. These investors understand the upside potential of stocks and want to participate in them, but are fearful of a bear market that could hit their portfolios in short-term windows. In addition, buffered ETFs are popular among investors who may want to lock in profits from more aggressive allocations without losing a lot of exposure to the stock market.
We feel that a buffered ETF is a novel tool for such clients. We first started using them in January 2020 and have increased allocations more recently with the S&P 500 at record highs. Buffered and other defined outcome ETFs provide the diversification benefits of an exchange-traded-fund, while also limiting the downside if the stock market takes a stumble. Let’s take a moment to look over how a buffered ETF is structured, and how the holding periods work.
The outcome period
The Outcome Period: The typical timeframe that a buffered ETF “exists” is for one year. The outcome period is precisely defined, because in order to offer a specific downside protection and upside cap level, the fund operator needs to use derivatives (a special kind of index option known as FLEX options) and lock in the parameters at the outset. If you buy into a buffered ETF on Day One of the outcome period, you will know exactly what your downside and upside parameters are. If you buy it any other time, those parameters could differ based on where the underlying index has traded since the outcome period began.
The company we work with, Innovator ETFs, has new defined outcome funds coming out each month. Each fund has a specified “run time” during which the upside cap and downside buffer are in place for.
The Upside Cap: In exchange for the downside protection, investors in buffered ETFs have to give up something – and that something is any gains the market makes above the upside cap. So in this sense a buffered ETF is like a bolted-on hedging instrument to a more standard index ETF. For example, if the upside cap was 11% in one year, and the S&P 500 index ends up rising 20% in the upcoming year, your gains would be “capped” at 11% and you’d pass up the other 9% the index rose. If the S&P 500 rose by 9%, the buffered ETF would also rise by 9% since it was within the cap (11%).
Getting protection on the downside
The Downside Buffer: This is the percentage of losses, established when the Outcome Period begins, that you won’t suffer if the market index that the fund tracks were to fall. So if the buffer amount was 10%, you’d keep your investment whole through the first 10% of losses the index suffered. For example, if over the course of the outcome period the S&P 500 falls 20%, then the buffered ETF will only fall 10%.
The Market Index: This is the base index that the buffered ETF will be tracking. The most common index’s that buffered ETFs track are the S&P 500 (large cap), Nasdaq (technology), and Russell 2000 (small cap). The buffered fund operator will go out and buy FLEX options for the base index, created with customized terms and cleared through the Options Clearing Corporation (OCC) for the specific objective of creating a buffered ETF.
The OCC is the world’s largest equity derivatives clearing house and is extremely reputable. The OCC is essential to the proper functioning of markets worldwide. In other words, we feel very confident using products they are involved with.
A live buffered ETF example
Let’s walk through an example using a buffered ETF that just came out last month. This is the Innovator S&P 500 Buffer ETF for March 2021, ticker: BMAR. BMAR’s outcome period runs for one year, from 3/1/2021-02/28/2022.BMAR buffers the first 9% of losses that the market index – in this case the S&P 500 ETF, SPY – may suffer through the end of next February. (SPY is an extremely liquid index ETF that tracks the S&P 500).
The upside cap was set to 17.42%; so if SPY rises 24% in the coming year, BMAR holders will see a max of 17.42% gains. But in a scenario where SPY is down 20% by next February, BMAR holders will only be down 11% (20%-9% =11%) during the outcome period, instead of the full 20% loss.
Lower Volatility – But Still Getting Exposure to High Growth Names
We like buffered ETF because it gives us exposure to the entire S&P 500, and lowers the volatility through the buffering mechanism itself. These ETFs are ideal for any investor who wants a smoother ride in the market, and is willing to sacrifice some upside gains to get it. In a large market rally, these types of ETFs will underperform. In a declining market, these ETFs will outperform. One final point is that these ETFs can be bought and sold daily just like any other ETF. That’s a big bonus because as client objectives or market dynamics change we can make adjustments accordingly.
Don’t want to miss anything?
Subscribe to our monthly newsletter for market insights.