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Buffer ETFs May Protect Investors from Outsized Losses. That Comes with a Cost.

Buffer ETFs May Protect Investors from Outsized Losses. That Comes with a Cost.

Inattentive use of these products risks exposing clients to losses and missed returns.

The past few years seen rapid growth in buffer ETFs. Since 2018, when these products were first introduced, the U.S. market has grown to 159 buffer ETFs with $37.99 billion in assets under management, according to The central selling point of buffer ETFs for financial advisors is that these vehicles offer clients downside protection—typically ranging from their first 10% to 15% of losses—while still allowing them to reap gains from investment in the equities market. That strategy can be particularly appealing during times of market volatility of the kind we saw in 2022, when the S&P 500 posted a loss of 18.11%.

Buffer ETFs, along with structured notes and annuities, serve as an essential tool for financial advisors to protect their clients’ portfolios from unexpected market risks, according to Jason Barsema, co-founder and president of investment platform Halo Investing Inc., which specializes in all three of these products. “It’s a hedge to your long equity; it’s not some mystical product that just gets lumped into the alternative investments drawer,” Barsema said.

He added that many advisors use buffer ETFs, structured notes and annuities as tactical tools, employing them when the market is overvalued or volatility is high. “And I think the absolute opposite, which is you should always have protection in your portfolio.” Some benefits buffer ETFs offer advisors compared to structured notes and annuities are that they are easier to rebalance within model portfolios, provide access to daily liquidity and cut down on counter-party risks that exist with the other options, according to Barsema.

However, the loss protection buffer ETFs offer comes with a cost—capping investors’ gains when the market goes up. Most of these products have a defined outcome period of 12 months. If the market posts either a moderate gain or a moderate loss during that time, investors reap the full benefits of these vehicles, industry insiders say. The calculation gets trickier when there are big swings in the market, possibly exceeding the offered downside protection or the cap on returns. The calculation also changes when investors buy in or sell out of a buffer ETF during the life of the series rather than holding their position for the entire duration because then the terms of downside protection and return caps set at the start of the series no longer apply and are subject to market conditions. Experts warn that investors might still experience sizeable losses or miss out on significant upside in those cases.

According to Lan Anh Tran, manager research analyst with Morningstar, buffer ETFs have proven that their model works as intended. However, they may only be a good choice for some investors and the suitability of their use in a portfolio depends on what the investor is trying to achieve. “People may not be fully aware of what they are giving up to get that downside protection,” she said. “It’s about the use case, and that’s where a little bit more education is needed.”

People who invest in buffer ETFs sign up for a very narrow range of outcomes, where both the downside and the upside they are exposed to are limited, since the fund managers of buffer ETFs have to cap returns to pay for the downside protection, Tran noted. For investors nearing retirement or those who can’t afford even small short-term losses, the protection they get might be a worthwhile sacrifice in exchange for the risk reduction, she said. On the other hand, clients with a long-term investment horizon who have no immediate need for liquidity might reap more significant benefits from investing in the equities market directly or in traditional ETFs.

While Barsema feels buffer ETFs can be helpful for all types of investors, he does counsel financial advisors to keep a close eye on how these products perform, especially when using them in model portfolios. He noted that there are now hundreds of different series of buffer ETFs on the market, which adds to the confusion advisors might feel. “If you are actively rebalancing your model portfolio, which series are you buying and which series are you selling? Advisors don’t want to get into the mindset where it’s just ‘Set it and forget it. This buffer ETF has a ticker. Therefore, I can just rebalance whenever I want.’ There is a lot more to it because you need to make sure you are rebalancing within the right series. If you don’t, there could be grave consequences.”

For example, if a financial advisor buys a buffer ETF series today that launched in February with a 10% loss protection and a 10% cap on returns and the underlying index has risen 5% since the launch, the client will only have exposure to another 5% of the upside, Barsema noted. At the same time, if the index gains a total of 2% by the end of the ETF series, the client that started participating in April will end up with a loss because their downside protection will not have kicked in yet.

Many advisors focus on the level of downside protection and the upside cap the ETF offers and don’t pay enough attention to when the series they are participating in launched, Barsema added. “It’s super critical to understand: how much upside do I have left, and when does my protection actually start to kick in?” he noted.

Even investors participating in a buffer ETF series for its entire duration can end up with an underperforming product if their market timing is bad. Tran offered an example of someone who started participating in an ETF with a 20% buffer in December/January 2021. She noted that person would end up largely insulated from the market’s sizeable losses during the subsequent 12-month period. However, “If you bought at the worst of 2022, maybe in July or August, the market wasn’t really going any lower. If you bought a fund with 20% protection at that point, by July or August 2023, you would be just sort of missing out on the gains the market re-couped over that 12 months.”

Morningstar recently ran a study that looked at S&P 500 returns on a rolling 12-month basis from the inception of the index in 1928 through 2023. The study found that within those time frames, the index experienced a loss of zero to 15% approximately 15% of the time, lost more than 10% another 17% of the time and posted a gain of more than 15% about 30% of the time. The results show that buffer ETFs won’t insulate investors from losses completely, yet they can limit their upside fairly often.

Meanwhile, Morningstar found some additional costs to investing in buffer ETFs compared to regular ETFs. Their fees are about 70% to 80% higher. Investors might be giving up any dividends from the underlying stocks with many buffer ETFs, unlike with the S&P 500. Annual yields on those range between 1.5% and 2%, according to Morningstar. For these reasons, Tran said buffer ETFs might be best suited for nervous investors who have difficulty staying in the equities market when it turns volatile and those who need easy access to liquidity.

“My recommendation for people who have a longer horizon is just to stay invested in equity for the long term. For investors with 10- to 15-year horizons, the index lost 20% in 2022 and by January of this year, it had already come back to where it was in December 2021. If you are able to stay invested, I would suggest that you invest in buying and holding and not trying to meddle too much with the equity sleeve.”

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