Should I Invest in a Buffered ETF?
Buffer ETFs, also known as Defined Outcome ETFs, are a newer investment product that hit the market in 2018. These products have been getting attention in the investment world and are growing in popularity. Therefore, we wanted to take some time to review these products and highlight important aspects that should be considered before investing. Let’s start by reviewing some terminology that’s important to know.
Buffer ETF: An Exchange-Traded Fund (ETF) designed to protect investors from a set amount of losses in exchange for capping how much gain they can capture.
Reference Asset: The index, asset, or fund a Buffer ETF tracks. For example, the return of your Buffer ETF could be determined by the performance of the S&P 500 index. You are not actually invested in the S&P500 index, but you are tracking it to determine how your Buffer ETF performs.
Buffer: The amount of loss that the ETF absorbs before the investor starts losing money, such as 20%. Going back to our example with the S&P500 index, let’s assume the index returned -30% during the period. If you have a 20% buffer, the first 20% loss is looked through and your return is -10%.
Cap: The most an investor can gain during an outcome period, even if the reference asset exceeds it. If a S&P500 Buffer ETF has a 20% buffer for example, gains might be limited to around 12% for the ETF even if the index performs higher during the period.
Outcome Period: A window during which a Buffer ETF’s stated floor and cap are in effect (one year is a common time period).
How do Buffer ETFs Work?
In plain language, a Buffer ETF provides an investor with downside protection on a predetermined percentage of losses but also has a cap on the amount of gain you can earn. During the outcome period, the value of the ETF changes based on factors such as the movement of the reference asset and its fixed buffer/cap levels, the time remaining in the outcome period, the implied volatility, and interest rates. Once the outcome period concludes, the investor is typically rolled into a new outcome period (unless they sell the security) with the same buffer protection level on the new value (there is nothing the investor needs to do). The cap rate could differ each period however and will be changed based on implied volatility and current interest rates.
Other important factors are tax treatment and dividends. For the most part, Buffer ETFs are taxed similar to other funds held in a taxable brokerage account. That means long-term capital gains rates as long as they are held for one year or longer. At the end of any outcome period, the gain (or loss) continues to be deferred until sold, generally making them tax efficient. However, buffer ETFs do not pay dividends, and the reference asset often does not include the positive impact of dividends on upside potential. This is important because it further limits its potential.
What are some Pros and Cons of Buffer ETFs?
Benefits that come with holding Buffer ETFs in your portfolio include:
Limited downside protection via the buffer.
They are traded on an exchange providing intraday liquidity.
No issuer credit risk since they are not a bank or insurance product (annuities and some structured notes carry issuer risk).
Tax efficiency - taxes on gains are deferred until the position is sold.
No forced maturity or liquidation. Until you sell, it will continue to roll forward.
Cons associated with buffered ETFs include:
A capped upside further limited by no dividends.
Losses that exceed the predetermined floor are unlimited (ex. if the floor is set at 10% but the reference asset drops 35%, the investor would face a 25% loss).
Expense ratios are generally higher than a regular ETF’s expense ratio.
Buffer ETFs are subject to market risks during the outcome period and will trade at losses/gains depending on the situation.
Smaller ETFs could have liquidity issues if you need to sell a large position.
It can be difficult for a buffer ETF to outperform a simple buy-and-hold portfolio over multi-year cycles. For example, if you incur a loss in a bad year and have your upside strictly capped during the subsequent recovery year, it takes significantly longer to rebuild your initial principal.
Who Could Benefit from Buffer ETFs?
Buffer ETFs can be an effective planning tool for certain people. A few situations are outlined:
Buffer ETFs can provide some protection in a down-market, reducing sequence-of-returns risk. This is the risk of needing access to your money during a bad market environment (think people approaching or starting retirement) resulting in distributions when your portfolio is down and thus locking in losses. Buffer ETFs can provide some protection here, but not full protection as noted.
Buffer ETFs could also provide some security for risk-averse investors with short-term horizons. Those time horizons could include future house payment needs, tuition payments or any large spending forthcoming.
Buffer ETFs can be used as a diversifier. For example, in a low interest rate environment, buffer ETFs can provide some upside potential along with some downside protection.
As a reminder though, Buffer ETFs do not provide complete downside protection. For individuals with long-term horizons and those with greater risk tolerance/capacity, these may not be the best choice.
Bottom Line
All investments carry risks and it’s important to weigh tradeoffs. You may be able to achieve your goals with other investment options at lower cost, for example. If you would like to discuss how Buffer ETFs may benefit your financial plan, reach out to one of our advisors. As a fee-only fiduciary, we provide conflict-free education and advice to optimize your financial journey.
Isaac Elsasser
Client Service Administrator
Find out more about Isaac on his profile page here! Be sure to listen to his episode on Finance in a Flash to hear how he ended up at Beacon Financial Strategies!