Are Buffer ETFs Worth a Place in Your Portfolio? Limit Downside

The current economic and financial environment is very uncertain. Amid soaring inflation and rising interest rates, investors are looking for ways to protect against the downside in the market. One of the more creative options for navigating this volatile market could be buffer ETFs. So, what are buffer ETFs?

Innovator Capital Management invented buffered ETFs in 2018. Since then, many providers have joined the wave. There are multiple options for individuals interested in buffered funds investing. As per Schwab, buffer ETFs have become one of the fastest-growing corners of the ETF market. Since 2018, over 100 buffer ETFs have launched and they have attracted over $14 billion in assets. These ETFs are becoming popular among investors who may not want to sit on the fence during market volatility but still want to hedge against potential losses.

Buffer ETFs, also known as defined-outcome ETFs, are funds that seek to provide investors with the upside of an asset’s returns usually up to a capped percentage while also providing downside protection on the first predetermined percentage of losses (for example, on the first 10 percent or 15 percent).

These ETFs don’t own any assets such as stocks or bonds but they use options to track the performance of an index. Think about forgoing some potential upside in an investment in exchange for protection against the potential downside. There's a trade-off in buffer ETF investing.

Another thing to note about buffer ETFs is that most of the buffer ETFs have a one-year outcome period, meaning that the caps and buffers apply only to investors who purchase on the rebalance date and hold the ETF throughout the entire outcome period. Investors who purchase after the rebalance date will receive different caps and buffers based on the performance of the referenced index between the rebalance date and when they purchased the fund.

The benefits of buffer ETFs are obvious during volatile and uncertain times. Buffer ETFs could be a good option for people nearing their retirement since they help preserve capital.

Some skepticism regarding buffer ETFs comes from the fact that if investors have a long enough holding period, they would still do better with a diversified portfolio of equities. Many hedge fund managers think that it's pointless to pay for downside protection over the long term as risk is limited over time with compelling returns. The expense ratio of these ETFs is usually 0.80 percent, which makes them expensive.

Buffer ETFs have a role to play in some people’s portfolios, particularly for risk-averse investors and retirement investors. For young investors and for people with long-term investment horizons, it would still make sense to go the traditional route and diversify their portfolios with equity being one of the major mainstays. While buffer ETFs promise to limit losses, they still have downside risks. As per Morningstar, “During the coronavirus-driven downturn from February 19 through March 23, 2020, losses on these funds ranged from about 11 percent to 27 percent.”