Do you love stocks but hate losing money when volatility strikes? There's a type of exchange traded fund that gives you exposure to stocks — and helps you reduce risk and sleep better at night.
Defined-outcome (or buffer) ETFs — which offer both the upside of stocks and downside protection — pull off this feat. What's the catch? You'll have to settle for less upside to limit (or avoid) losses.
New Choices To Reduce Risk
BlackRock, for example, recently launched the iShares Large Cap Max Buffer Jun ETF. It's one in a new series of buffer ETFs. The ETF tracks the iShares Core S&P 500 ETF and gives investors 100% downside protection (the buffer). But it also caps, or limits, gains at 10.6% for the one-year "outcome period" from July 1, 2024, to June 30, 2025.
So, if the S&P 500 declines in that 12-month stretch, an investor who bought at the start and held until the end will suffer zero losses. However, if the market rises more than 10.6%, the investor forfeits any gains beyond that.
With stocks at record highs and a record $6.15 trillion in cash sitting on the sidelines in money market funds, buffer ETFs might be the antidote for those too timid to put cash to work. A defined-outcome ETF, which mitigates risk, could also give jittery investors a reason to stay invested during periods of market volatility.
Buffer ETFs Take Off
Buffer ETFs are gaining a following. The first buffer ETF launched in 2018 by ETF provider Innovator. Investors with a defensive streak or an aversion to risk are buying in. That's especially true after 2022, when both stocks and bonds tanked and provided little diversification protection.
There are now 283 buffer ETFs offered by 15 different ETF issuers with $48.8 billion invested in them, according to CFRA Research data through July 2. The top two issuers are First Trust and Innovator. This year alone, defined-outcome ETFs have taken in $7.1 billion in new investments, a 17% rise.
Defined-outcome ETFs are designed for outcomes ranging from conservative to aggressive. The ETF issuer utilizes an options trading strategy to provide the downside protection.
Hedge Your Bets To Reduce Risk
Buffer ETFs offer you a way to hedge your bets but stay invested. They help investors better predict portfolio outcomes and manage through rocky markets. Limiting losses can help investors feel more comfortable tiptoeing back into the market with idle cash.
Aniket Ullal, head of ETF Research at CFRA, says these types of funds appeal to specific types of investors.
"They are most appropriate for investors who want to move out of cash and be invested in equities but also want some downside protection," said Ullal. "They are also appropriate for investors who may take a view that the market may appreciate at a moderate rate and, therefore, feel they are not giving up upside in exchange for downside protection."
Buffer ETFs Help Some Investors Reduce Risk
Buffer ETFs might make sense for retirees or those nearing retirement who need stocklike returns but can't afford market drawdowns, says Rachel Aguirre, head of U.S. iShares Product at BlackRock.
"These investors are really looking to protect the wealth they've built, but they're also looking to generate income and growth during retirement," said Aguirre. "We believe (buffer ETFs) can be a powerful tool to help investors stay invested rather than trying to time the market."
Buffer ETFs, though, may not be the best product for investors in their 30s and 40s saving for retirement, says Steven Conners, founder and president of Conners Wealth Management. This age group, he says, is better off investing for growth, and have the benefit of time to ride out down markets. "They can leave their money invested for 20 or 30 years," said Conners. "Why give up the growth?"
What's A Buffer ETF?
Buffer ETFs track an asset, typically the S&P 500. Some track the Nasdaq, foreign stock indexes and U.S. Treasury benchmarks. This flavor of ETF has an "outcome period," such as a quarter, six months, one year or two years, in which the upside cap and downside buffer are in effect. The upside cap is the maximum return the fund can earn over the full outcome period. The downside buffer is the maximum loss the fund seeks to protect the investor from.
In general, the less downside protection you get, the more you can earn on the upside. And vice versa: The bigger the downside cushion is, the smaller gain you'll earn. It's up to the investor to select a risk-and-reward scenario with which they're comfortable.
Reduce Risk: Looking At Returns
An investor's return at the end of the outcome period depends on the performance of the underlying asset, such as the S&P 500. Buffer ETFs can be held indefinitely. They reset at the end of each outcome period and roll into a new buffer ETF with a new upside cap, which is determined by interest rates and volatility.
There are a variety of buffers to consider based on your risk tolerance and investment goals. In addition to 100% buffers, which wipe out all loses, the buffer, or downside protection, could be 10%, 15%, 20% or 30%.
Someone who wants to protect against a correction, or a market drop of 10%, for example, might consider a 10% buffer ETF. An investor who fears a bear market, or 20% market plunge, might see value in a 20% buffer, perhaps one that resets quarterly.
Why? Virtually all (97%) of the three-month losses for the S&P 500 were less than 20%, according to data from Innovator ETFs. A retiree that can't stomach any losses might opt for a 100% buffer.
Buffers only protect you from losses up to the buffer level. For example, if you bought a 10% buffer ETF that tracks the S&P 500, such as Innovator U.S. Equity 10 Buffer ETF with a quarterly outcome that ends Sept. 30, the fund will cover any losses up to 10%. But if the S&P 500 falls more than the buffer amount, say it plunges 25%, you'd be on the hook for the remaining 15% of the loss.
Capping The Upside
On the upside, if your quarterly gain is capped at 3.34% and the S&P 500 rallies 13.34% during the outcome period, you won't capture the index's full return. You'll miss out on that additional 10% gain.
The risks of defined-outcome ETFs "lie in the extremes," according to a blog post from Swan Global Investments. "If the market is up a lot, the buffered ETF will not enjoy gains beyond a certain point. If markets sell off too much, the buffered ETF is exposed to open-ended losses."
So, it's all about trade-offs with buffer ETFs. No doubt, avoiding losses up to whatever buffer level you buy into is a perk. But you must also be comfortable with giving up gains if the market outruns the upside cap.
Portfolio Strategies For Buffer Or Defined-Outcome ETFs
There are many ways an investor can integrate buffer ETFs into their portfolios.
First, such ETFs boost stock exposure with less risk. For example, an investor who holds 60% stocks and 40% bonds may consider upping their stock allocation to 70% (adding a 10% buffer allocation) and trimming their bond holdings to 30%. "If you want to add some percentage points to the growth side of the portfolio, you take it from the 40% (bond weighting)," said Conners.
They are also a stock diversifier. Buffer ETFs can be used to add a defensive slice to a stock allocation. The goal? To reduce equity declines during down markets. For example, if you hold a 60-40 stock and bond mix, you can replace a portion of that existing core stock position with a buffer ETF, says BlackRock's Aguirre.
Lastly, buffer ETFs can substitute for cash or bonds. Investors with substantial allocations to fixed income and who are close to retirement may be looking for more growth via stocks. Shifting a portion of a bond portfolio to a buffer ETF may provide more growth while keeping portfolio risk in check. "It can be a compelling alternative to Treasuries and other bond instruments," said Aguirre.
The Downsides To Buffer ETFs
Like any investment, pay attention to costs. The average expense ratio on a buffer ETF is 0.78%, according to ETF.com. That's higher than the 0.53% cost of the average stock ETF.
It's best to buy buffer ETFs about a week before the start of the new outcome period and hold it to maturity (almost like a bond). That way you get the advertised defined outcome (buffer and cap) from the ETF. If you buy after the start date, both the buffer and cap can change due to market conditions. Most buffer ETFs are issued on a monthly or quarterly basis.
"Buffer ETFs make a lot of sense," said Conners. "This is more a risk-management technique, almost like a fixed annuity, without tying up your money forever."
