Written by: Peter Mastrantuono
There is an old Wall Street adage that “stocks climb the stairs up and take the elevator down.” In March it seemed that the elevator was in a freefall. But, what if individuals could gain equity exposure that limits the downside risk? Would the protection against losses still be worth it if it came at the cost of some of the upside?
According to a recent report by The Wall Street Journal investors are pouring record money in what are known as “buffer ETFs.” Through March, investors have added about $1.9 billion this year to buffer ETFs, well ahead of the $1.49 billion invested in all of 2019.
How Buffer ETFs Work
Similar to the structured notes created by the big Wall Street firms (but without the liquidity or credit risk concerns), buffer ETFs seek to provide equity exposure to investors, along with some protection against market losses. In exchange for that protection, investors’ gains are capped. Buffer ETFs will each have different trade-offs, but a typical offering may protect investors against the first 10% or 15% of a market decline and limit potential gains, e.g. 15%. Investors also forfeit any dividend payments that may be associated with conventional index investing.
To accomplish this objective, buffer ETFs generally purchase options on the stock index to which it is tied, for instance, the S&P 500 or NASDAQ 100. Such ETFs pursue predetermined performance outcomes (e.g., protect against first 15% of market losses; realize index return, capped at 20%.) over an outcome period (e.g., June 1, 2020 to May 31, 2021).
These outcome objectives, however, are relevant only to initial investors. Buffer ETFs traded subsequent to their initial offering may provide varying levels of protection and market gain caps as a result of fluid stock market conditions.
These investment products are complex. If investors do not understand them or are not willing to hold them for the full duration of the outcome period, they may not be suitable investments. These funds do not protect investors completely from market losses, and that any protection provided by the buffer is not guaranteed.
Moreover, index options and the index are not always perfectly correlated. For instance, interest rates, implied volatility and demand dynamics for the index options may affect the price of options.
After a year, buffer ETFs reset their performance outcome parameters, requiring investors to determine if the trade-off remains attractive to them.
Assessing Whether Buffer ETFs Make Sense
Buffer ETFs shouldn’t be viewed as a long-term investment as they are hobbled by high fees, an absence of dividends (a significant contributor to long-term equity performance) and a ceiling on gains. However, they may be best viewed as a temporary place for holding a portion of equity assets when investor uncertainty is elevated and capital protection becomes a higher priority.
There are many ways to protect against stock market losses, while still participating to some degree in its potential upside. Buffer ETFs are just the newest tool for doing so. Investors looking to achieve protection against stock market losses should work with an experienced financial advisor to discuss all the available options, including buffer ETFs.
Peter Mastrantuono is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. Peter worked for over 30 years in the wealth management industry, focusing on retirement planning, investing, asset allocation and financial planning.
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