Funds that protect against losses drew record amounts of cash last year. What to know about buffer ETFs

Published Mon, Jan 27 20253:02 PM EST

More investors are moving into buffer exchange-traded funds in a quest to protect against market losses. The products, also known as defined-outcome ETFs, attracted a record $14.5 billion in new cash last year, according to State Street Global Advisors. The funds use option contracts that can provide some buffer against market losses, but they come at a cost. "If this is meant to be more of a defensive equity position, you are capping some of your upside to manage some of your downside," said Matthew Bartolini, head of SPDR Americas research at State Street. That means the funds could underperform in an up market, but outperform in a down market. The funds have defined outcomes that are set at the beginning of the period and only apply at the end of the outcome period. For example, a January series ETF may start on Jan. 1 and end Dec. 31 each successive year. In 2020, defined-outcome ETFs only held about $2 billion in assets, according to Morningstar. That has since ballooned to $47 billion, said Bryan Armour, Morningstar's director of passive strategies research. "As investors are more comfortable with those using options in some of these pre-packaged funds, then it becomes a viable option for a number of different investors," he said. "This keeps people in the stock market, but without, necessarily, as much risk if stocks drop." As the assets grew more popular, more ETFs were offered. BlackRock , the world's largest asset manager, launched its first buffer fund products in 2023. "The ETF wrapper has kind of democratized access to these strategies to the masses, so that they're lower cost, more transparent [and] potentially more tax efficient," said Robert Hum, BlackRock's U.S. Head of factor and outcome ETFs. BlackRock currently sponsors five products with different levels of protection. Its iShares Large Cap Moderate Buffer ETF , for example, tracks the iShares Core S & P 500 ETF and protects against the first 5% of losses over each calendar quarter. The iShares Large Cap Deep Buffer tracks the same underlying ETF, but has a buffer of about 5% to 20%. It's iShares Large Cap Max Buffer offers as much as 100% downside protection. All have net expense ratios of 0.50%. IVVM 1Y mountain iShares Large Cap Moderate Buffer ETF over the past year How the products work The ETFs use option contracts to shield investors from a set percentage of losses on an underlying index, typically the S & P 500 . The most common approach is to use three different options with the same expiration, according to a Morningstar report . A long, deep-in-the money call option provides synthetic exposure to the index. 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, Morningstar says. The loss protection varies across products. For instance, an ETF can buffer against the first 10% of an index's loss, but also cap returns past a certain point, such as 15%. Are they right for you? While buffer ETFs are easily accessible, the strategy behind them is complex. Therefore, investors should do their homework. They may not make sense for younger investors because the ETFs will likely underperform the underlying index over long time frames, said Morningstar's Armour. There are also some minor differences that can add up, like fees, and the fact that the ETFs track a total return, so investors lose out on dividends, he said. "The biggest thing to be aware of is that up years are just as meaningful to long-term success as down years," he said. "Stock returns tend to have fat tails, meaning they have really good years, or they have really bad years in a higher proportion than would be expected," he added. "So you're cutting off the good tail and keeping the bad tail. If you have a buffer of 9%, great, but if [the underlying index] goes down 50% — is being down 41% that much better?" On the other hand, it could be an option for those who want less volatility, such as investors nearing or in retirement. PDEC 1Y mountain Innovator U.S. Equity Power Buffer ETF - December over the past year Stuart Chaussée, founder of Stuart Chaussée and Associates, manages about $400 million for clients and has about $325 million in buffer ETFs. Most of his clients are either retired or nearing retirement. "I wanted to reduce the volatility in the market, reduce the likelihood of large drawdowns, but also give them the potential to outperform bonds or risk-free investments," he said. Investors should decide which index they'd like to track, and the outcome period — which can be anywhere from three months to two years, said Chaussée. They also want to get in at the start of the defined period to get the full benefit. He typically goes with an outcome period of 12 months and largely uses buffer ETFs that track the SPDR S & P 500 ETF Trust . He generally sticks with downside protection of around 10% and believes 100% protection can be "overkill." "I'd rather have a higher upside potential for the client," he said. Protection against a frothy market Investors who aren't expecting big market returns this year may also consider moving some money into a buffer ETF, Armour said. "A lot of people see a somewhat frothy market right now, and some of the concentration at the top of the U.S. market in particular, and potentially they want a hedge against a drop," he explained. The funds may also shine more brightly as investors move out of cash, BlackRock's Hum said. There is currently $6.9 trillion sitting in money market funds, according to the Investment Company Institute . That's equal to more than 30% of annual U.S. gross domestic product. [Investors are] worried about getting into the equity markets at stretched valuations," Hum said. "Buffer ETFs are a nice way to inch their way back into the markets and have some confidence, given the protection levels that they have." The same could be said of younger investors who are concerned about the market's valuations but still want to be invested, he added.