Buffer ETFs promise investors downside protection — at a cost.

Investors looking for protection against market downside are turning toward buffer exchange-traded funds, also known as defined-outcome ETFs. The funds use option contracts that could provide some buffer against market losses, but they don’t come for free. “That downside protection … is coming at the cost of giving up some of the upside of the index,” said Lan Anh Tran, manager research analyst at Morningstar. “That’s the kind of trade-off and promise that these products offer.” Buffer ETFs have exploded in popularity in recent years, although they are still a small slice of the overall industry. Assets have grown to $36.9 billion as of the end of April, from just some $183 million in December 2018, according to Morningstar. The defined outcomes are set at the beginning of the period and only apply at the end of the outcome period. For instance, a January series ETF may start on Jan. 1 and end Dec. 31 each successive year. “Investors are really interested in the sort of peace-of-mind products that can help them stay invested,” Tran said. Investors drawn to these aare primarily those who are either close to retirement or are retired, said Todd Sohn, ETF and technical strategist at Strategas Securities. They are looking to preserve capital to fund their lifestyles. “Most of those investors lived through the tech bubble and financial crisis and they think they cannot risk the possibility, however slim, of another meltdown,” he said. However, those with a longer time horizon may want to think twice, Tran said. “Over the long run, if you look at the return distribution for the S & P 500 , you’ll be fine if you have a five-year horizon and just stay invested, but it’s hard to do so,” she said. How buffer ETFs work Managers use a set of equity options when building a fund. The most common approach uses three layers of options with the same expiration , Morningstar explained in a 2023 paper . A long deep-in-the money 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 short a call option, according to Morningstar. The result is a defined buffer against losses, which varies by product. For instance, it can protect against the first 10% of the index’s loss but caps returns past a certain point, such as 15%. In essence, these are sophisticated assets wrapped in an ETF, Strategas’ Sohn said. “It is just a packaged solution of a really complex investment strategy that is really efficient for a lot of people out there,” said Sohn, who called them the “next step” in ETFs. “I think it will get bigger and bigger as time goes on.” Innovator Capital Management is a pioneer in the defined-outcome ETF space, bringing a product to market in 2018, although buffer mutual funds came on the scene a couple years earlier. BJUL mountain 2023-07-01 Innovator’s U.S. Equity Buffer ETF, 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 that offers 100% downside protection. The first in the line, Calamos S & P 500 Structured Alt Protection ETF (CPSM) , began trading May 1. The firm announced that the offering has a 9.81% upside cap rate. Other ETFs will track the Nasdaq 100 and the Russell 2000 . The funds have an annual expense ratio of 0.69%. Calamos’ head of ETFs Matt Kaufman sees the products appealing to those who want to save cash for a defined period, for retirees who want to try to outpace inflation without downside risk and those who think the market may be frothy and want to take risk off the table. “This is a tax efficiency play,” he said. Gains on ETFs held more for a year are subject to capital gains taxes, while yields 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 in and allow it to grow,” he said. “If you want to take income off of that, you can pay yourself off of that capital appreciation.” Innovator also offers products with 100% protection, like its two-year Equity Defined Protection ETF (AAPR) , which tracks the SPDR S & P 500 ETF Trust (SPY) and starts April 1 with an 18% upside cap. It has an expense ratio of 0.79%. What to consider when investing There are a number of factors to consider before investing in a buffer ETF. First, figure out how much protection you want on the downside. The amount of downside protection affects your upside cap, Sohn said. Although your money isn’t locked up, timing also matters. You should buy the ETF on the first day it is available and then stick with it until the underlying options expire, which is typically a year, to get the full benefit, he said. For instance, the next available ETF would be a June series. “That is money you want to set aside and not touch in the meantime,” he said. However, there are some products that ladder options contracts that expire on different dates, which could provide more flexibility, Morningstar’s Tran noted. Those products, like the JPMorgan Hedged Equity Laddered Overlay ETF (HELO) , do not have specific loss thresholds or upside caps, but overall provide a narrower outcome range and smoother volatility, she said. HELO 1Y mountain JPMorgan Hedged Equity Laddered Overlay ETF year to date In addition, you’ll have to be comfortable potentially missing out on the market’s upside if the index rises above the ETF’s cap. “If [the fear of missing out] is going to bother you, maybe these aren’t the best products for you,” Sohn said. Investors are not only risking an opportunity cost by missing out on potential returns. Buffer ETF fees also tend to be higher than those of average ETFs. The average fee for a buffer ETF is around 0.75% to 0.80%, Morningstar’s Tran said. “It’s starting out at quite a high point, [but] we do expect it to go lower as there is more competition in this space. It just has not really happened yet,” she said. Investors also don’t receive the dividends of the underlying stocks. The fees and loss of dividends combined “drive roughly a 2%-3% wedge between an S & P 500 ETF and a defined outcome ETF,” Morningstar wrote in its 2023 report. Investors should also understand the firm that is offering the ETFs. Some firms, 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 providers are younger firms and so maybe a little bit of due diligence into who is actually handling these products — what are the risks and reputation and information you can get on these managers — would be good practice as well,” she said.