Buffer ETFs promise investors downside protection – at a cost.

Investors looking for protection against market declines turn to buffer exchange-traded funds, also known as defined outcome ETFs. The funds use options contracts which could provide some protection against market losses, but they are not free. “This downside protection… comes at the cost of giving up some of the index’s upside,” said Lan Anh Tran, a research analyst at Morningstar. “That’s the kind of compromise and promise these products offer.” Buffer ETFs have exploded in popularity in recent years, although they still represent only a small portion of the overall industry. Assets rose to $36.9 billion at the end of April, up from just $183 million in December 2018, according to Morningstar. The defined results are set at the start of the period and only apply at the end of the results period. For example, a January Series ETF may start on January 1 and end on December 31 of each successive year. “Investors are really interested in the type of peace-of-mind products that can help them stay invested,” Tran said. Investors attracted to these funds are primarily those who are near or in retirement, said Todd Sohn, ETF and technical strategist at Strategas Securities. They seek to preserve their capital to finance their lifestyle. “Most of these investors lived through the tech bubble and the financial crisis and think they can’t risk the possibility, however small, of another collapse,” he said. However, those with a longer time horizon may want to think twice, Tran said. “Over the long term, if you look at the distribution of S&P 500 returns, you’ll be fine if you have a five-year horizon and just stay invested, but that’s hard to do,” she said. How Buffer ETFs Work Managers use a set of stock options when building a fund. The most common approach uses three layers of options with the same expiration, Morningstar explained in a 2023 article. A deep long call option provides synthetic exposure to an index, most commonly the S&P 500 .A long put spread protects against losses up to a specified amount. To finance the cost of the put spread, managers sell a call option, according to Morningstar. The result is a defined buffer against losses, which varies by product. For example, it can protect against the first 10% loss of the index, but caps returns beyond a certain point, for example 15%. Essentially, these are sophisticated assets wrapped in an ETF, Strategas’ Sohn said. “It’s just a holistic solution to a really complex investment strategy that’s really effective for a lot of people,” said Sohn, who called them the “next step” in the ETF space. “I think it will become more and more important as time goes on.” Innovator Capital Management is a pioneer in the defined outcome ETF space, having launched a product to the market in 2018, although buffer mutual funds appeared a few years earlier. Montagne BJUL 01/07/2023 ETF Innovator’s US Equity Buffer, July series since July 1, 2023 Since then, competitors have followed suit, including PGIM, Allianz and BlackRock. Recently, Calamos announced a new product line of 12 ETFs offering 100% downside protection. The first in the lineup, the Calamos S&P 500 Structured Alt Protection ETF (CPSM), began trading on May 1. The company announced that the offering had an upside capitalization rate of 9.81%. Other ETFs will track the Nasdaq 100 and the Russell 2000. The funds have an annual expense ratio of 0.69%. Matt Kaufman, Calamos’ head of ETFs, sees the products as attractive to those who want to save money for a set period of time, to retirees who want to try to outpace inflation without downside risk, and to those who believe that the market is frothy and want to take risks. Table. “This is a tax efficiency game,” he said. Gains on ETFs held for more than one year are subject to capital gains tax, while returns on cash products like certificates of deposit are subject to income tax. Treasury bonds are subject to federal income tax but are exempt from state and local taxes. That tax burden and inflation can erode a CD’s yield, Kaufman argued. “Whereas here you can leave your money and let it grow,” he said. “If you want to earn income from it, you can pay yourself back with that capital gain.” Innovator also offers products with 100% protection, like its two-year ETF Equity Defined Protection (AAPR), which tracks the SPDR S&P 500 ETF Trust (SPY) and starts April 1 with an upside cap of 18 %. Its spending rate is 0.79%. Things to consider when investing There are a number of factors to consider before investing in a buffer ETF. First, determine how much protection you want in the event of a downturn. The amount of downside protection affects your upside cap, Sohn said. Even if your money isn’t tied up, timing also matters. You need to buy the ETF the first day it’s available, then hold onto it until the underlying options expire, which is usually a year, to take full advantage of it, he said. For example, the next ETF available would be a June series. “That’s money you want to put aside and not touch in the meantime,” he said. However, some products stagger options contracts that expire on different dates, which could provide more flexibility, Morningstar’s Tran noted. These products, like the JPMorgan Hedged Equity Laddered Overlay ETF (HELO), do not have specific loss thresholds or upside caps, but overall offer a narrower outcome range and smoother volatility, she said. declared. HELO 1Y Mountain JPMorgan Hedged Equity Laddered Overlay ETF since the beginning of the year. Additionally, you will need to be comfortable with the risk of missing out on the market’s rise if the index exceeds the ETF’s cap. “If [the fear of missing out] “It’s going to bother you, maybe these aren’t the best products for you,” Sohn said. Investors not only risk an opportunity cost by missing out on potential returns. Buffer ETF fees also tend to be higher than average ETFs. The average fee for a buffer ETF is about 0.75% to 0.80%, Morningstar’s Tran said: “It starts at a pretty high point. [but] we expect it to drop as there is more competition in this area. It just hasn’t happened yet,” she said. Investors also don’t receive the dividends from the underlying stocks. The combined fees and loss of dividends “result in a spread of about 2 to 3% between an S&P 500 ETF and an S&P 500 ETF. a defined outcome ETF,” Morningstar wrote in its 2023 report. Investors should also understand the company that offers the ETFs. Some companies, like JPMorgan, BlackRock, Parametric and AllianceBernstein, have experience with options in other parts of their businesses and have established a name for themselves, Tran said. “Some of the other vendors are younger companies and so maybe a little due diligence on who is actually managing these products – what the risks are, the reputation and the information you can get on these managers – would be helpful. also be a good practice,” she said.

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