What Are Buffer ETFs? Everything You Need to Know.

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More than a decade of high correlation among all sorts of assets has made diversification a challenge, and inflation could make things even worse. That has led some investors, especially those in or nearing retirement, to rethink the traditional stock/bond mix and look to more-creative options to protect against a down market, such as “buffer” exchange-traded funds. While these funds generally do what they promise, and therefore could relieve some anxiety, they are not a silver bullet.

First, these complicated funds require some explanation: Buffer ETFs don’t own any actual stocks or bonds; instead, they use options to track the performance of an index. Investors forgo some potential returns for protection against some losses. The ETFs buy put options, which give them the right to sell the stocks in an index at a predetermined price. So, when the index falls below the put’s strike price, the fund has a floor under its losses. They also sell call options, which give the buyer the right to purchase stocks for a specific price. If shares rise beyond the call price, the options buyer would exercise the option; this limits the upside for the ETF investors.

Buffer ETFs are also known as defined-outcome ETFs, since this protection is in place for a specified period of time. They are modeled after options-based structured notes, but are cheaper, more liquid, and have no minimum investment or credit risk. “These products cater to reluctant investors—people who realize they should have some equity exposure but are afraid of losses,” says Amy Arnott, portfolio strategist for Morningstar.

But investors shouldn’t avoid losses at any cost—and the cost of buffer ETFs can be very high, both directly and indirectly. Buffer ETFs typically charge 0.8% annually, considerably more than the index funds whose performance they track. What’s more, because buffer funds own options, they also don’t receive dividends from stocks. Both factors will erode returns.

More importantly, buffer ETFs appear to be at odds with how markets generally perform. Statistically speaking, stocks tend to have positive returns more often than not. That means buffer-fund shareholders are more likely to sacrifice upside returns than benefit from downside protection. Barron’s looked at the

S&P 500’s

trailing 12-month returns since 1979 and plotted the probabilities of different outcomes. The index gained more than 15% during a third of those periods, and posted losses only a fifth of the time.

Over longer time periods, the risk/return profile of buffer ETFs look pretty similar to a well-balanced, 60% stock/40% bond portfolio, says Arnott. “It’s not necessarily better than a much simpler strategy,” she says.

Note: Data as of June 17; *maximum potential gains for the remaining period, after fees and expenses; **maximum potential loss reduction for the remaining period, after fees and expenses.

Sources: Innovator ETFs, First Trust

In today’s somewhat precarious market, however, some short-term protection can look particularly attractive. “It makes more sense in a situation when I really don’t like the bond market very much, [and I want] to get returns and protection some other way,” says Larry Carroll, CEO of Charlotte, N.C.–based advisory firm Carroll Financial. He started buying buffer funds for his clients last year, most of whom are individual investors over 65 years old.

Investors willing to pay to limit losses in their stock portfolios need to choose carefully. There are more than 120 buffer ETFs on the market, all launched within the past three years. Assets have grown rapidly: There’s $7 billion in these ETFs, more than in all other liquid alternative ETFs. The two key aspects of buffer ETFs that investors need to understand are exactly what amount of loss is protected, and the time period that protection covers.

The amount of protection. For starters, no ETF promises zero losses. How much you lose depends on the ETF and, of course, how much the market falls. The Innovator S&P 500 Buffer ETFs, for example, protect investors from the first 9% of losses, while the Innovator S&P 500 Power Buffer ETFs absorb the first 15% losses. Some buffers don’t kick in until stocks fall a certain amount, such as 5%; some protect from initial losses but can fall even more than the underlying index if the drawdown is too deep; some don’t promise a particular buffer, just a target range.

Most investors are better off in simpler ETFs that absorb any losses up to a certain threshold. Generally speaking, the more protection, the less participation in the upside. Carroll finds the 15%-buffer funds most appealing, because more protection would have cost him too much potential gains.

The protection period. Each buffer ETF has a defined outcome period, usually one year, with specific starting and expiration dates; that is the only period for which the stated buffer is in effect. In other words, a fund that protects the first 10% of losses will count the drop from the start date to the expiration date, not from the investor’s time of purchase to sale. Investors who buy in the middle of the defined period will have different buffers and caps for the remaining time, depending on where the market is when they buy. The cap on gains is usually higher in more-volatile markets. The only way to guarantee you’ll get the stated results, Arnott says, is if investors buy at the beginning of the period and hold to the end.

Write to Evie Liu at evie.liu@barrons.com