Volatility over the last few weeks has many investors asking for a way to get equity returns but without equity downside risk. In recent years the advent of buffer ETFs seems to have solved this riddle. Using options on the desired exposure, buffer ETFs seemingly allow investors to have 0 (or close to it) downside risk while still participating in equity market upside.
With any innovation, details of how it works are key. These ETFs are typically issued for a short period – say 1 year – and buy an index like the S&P 500 as well as puts on it to protect downside. Because the puts are not free, the ETF also sells calls to pay for the puts. The result is that for a period of 1 year only, the ETF cannot drop below a certain level but also cannot go above a certain level. And that level doesn’t change for the life of the ETF.
So the downside risk is covered, but the upside limit presents a challenge. A recent S&P 500 buffer ETF limits the upside to ~7% over the next 12 months. Eagle-eyed investors will immediately spot the first issue: the S&P 500 has averaged 10% annual returns for the last ~70 years. So in an average year, this ETF would leave ~3% on the table. But that’s only the start of the issues. What if the index is up 7% within 6 months? The calls and puts mean the ETF is up only 3%! And worse, not only are investors limited to ~4% upside in the remaining 6 months, they also now have 3% downside as the upper/lower limits don’t change for the life of the ETF. Attention to detail on the specifics of the buffer ETF in question, as well as a superhuman ability to time the market in the short-term, are required for success.
But these are features not bugs. The ETFs participate less in the upside but are meant to deliver downside protection. AQR recently published a study confirming as much – most options funds trailed the market since 2020 but did deliver lower drawdowns. On the surface, a reasonable result for those who want it, but of course the key question is whether this downside protection was delivered better than the “tried and tested” approach of having less equity risk, say via a 70% stock and 30% bond allocation. The results here were not encouraging. To quote AQR: “more than two thirds of all funds deliver lower returns with more risk than a simple combination of passive equities and T-Bills”. And to make matters worse, “81% have worse drawdowns than the simple ‘passive equity plus cash’ combination”.
So what’s the punchline? Buffer ETFs protect downside, but not perfectly and for short periods only. They also cap the upside. We believe it is difficult to time markets to this level of detail, which means investors are likely to underperform simpler portfolios designed to achieve similar outcomes. Instead, investors should target these simpler portfolios, which includes identifying the right level of risk for their financial situation, diversifying across asset classes to ensure smoother returns, and adding safer assets to portfolios ahead of market concerns.
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The information provided is for educational purposes only. The views expressed here are those of the author and may not represent the views of Leo Wealth. Neither Leo Wealth nor the author makes any warranty or representation as to this information’s accuracy, completeness, or reliability. Please be advised that this content may contain errors, is subject to revision at all times, and should not be relied upon for any purpose. Under no circumstances shall Leo Wealth be liable to you or anyone else for damage stemming from the use or misuse of this information. Neither Leo Wealth nor the author offers legal or tax advice. Please consult the appropriate professional regarding your individual circumstance. Past performance is no guarantee of future results.
This material represents an assessment of the market and economic environment at a specific point in time. It is not intended to be a forecast of future events or a guarantee of future results.
Exchange Traded Funds (ETF’s) are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from the Fund Company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
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The Standard & Poor’s 500 (S&P 500) Index is a free-float weighted index that tracks the 500 most widely held stocks on the NYSE or NASDAQ and is representative of the stock market in general. It is a market value weighted index with each stock’s weight in the index proportionate to its market value.
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