Nearing or entering retirement often shifts financial priorities from growth to preservation. Buffered ETFs might appeal to those looking to protect their savings amidst market volatility.
These investments, known for defined outcomes, aim to limit losses while capping gains. They help investors remain in the market during turbulent times by offering protection against significant downturns.
Buffered ETFs, or buffer/defined-outcome ETFs, have grown significantly, from just over $5 billion in assets in 2020 to nearly $50 billion today, according to Morningstar. Despite their popularity, they are frequently misunderstood.
Options Strategies in Buffered ETFs
Buffered ETFs employ options strategies. Erik Ogard, co-founder of BufferLABS, explains that these funds usually purchase deep in-the-money S&P 500 call options for market exposure. They define outcomes by:
- Selling a call option to cap returns.
- Purchasing a near-the-money put for downside protection.
- Selling a deep out-of-the-money put to finance the protective leg.
This structure, called a "collared put spread," provides known downside protection (commonly 10%, 20%, or 50%) in exchange for limited gains over a typical 12-month outcome period.
Who Should Consider Buffered ETFs
Dan Kern, Chief Investment Officer at Nixon Peabody Trust Company, advises that buffered ETFs are unsuitable for long-term investors due to the time horizon required to weather volatility. Instead, they suit investors with shorter timeframes and lower risk tolerance. Retirees might find them beneficial, as buffered ETFs can mitigate risks related to withdrawing funds during market downturns.
Other suitable situations include retirees taking regular withdrawals, investors with low risk tolerance, or those facing sequence-of-return risk.
Advantages for Retirees
Buffered ETFs provide downside protection described by Ogard as “insurance against prolonged market decline.” This safety net can shield investors from losses between 5% and 50%, crucial for retirees who cannot afford major setbacks.
These ETFs appeal to conservative investors by offering protection rather than equity market-like returns. They may help account holders manage sequence-of-returns risk by cushioning downturn impacts.
Performance and Emotional Stability
Buffered ETFs have demonstrated resilience, as shown in 2022 and 2023. When the S&P 500 fell nearly 19%, some buffered ETFs only lost 4-5%. When the market rebounded 24%, they returned 18-19%.
Potential Risks of Buffered ETFs
Ogard highlights the complexity of buffered ETFs, making them challenging for DIY investors. Technical terms like "remaining buffer" and "outcome period" may confuse. Higher fees compared to index ETFs also pose a downside.
Investors should understand timing in relation to the protected period and potential limitations if buying or selling mid-cycle. These investments are not ideal for frequent trading due to potential interim performance unpredictability.
Application and Strategy
Kern suggests thorough research before engaging with buffered ETFs, as many variations exist. A bucket strategy might allocate buffered ETFs for short-term or income needs, complementing traditional equities for growth.
Allocation and Implementation
Ogard suggests retirees might allocate more than half of their equity to buffered ETFs, considering financial and psychological resilience against significant market drops.
Laddered buffered ETFs facilitate hands-off investment by resetting monthly, reducing entry and exit timing concerns. Popular choices include First Trust’s BUFR and Innovator’s laddered strategies.
Overview of Buffered ETFs
- iShares/BlackRock Buffer ETFs: Offer capped upside with specific downside protection.
- Innovator Buffer ETFs: Pioneers of defined-outcome ETFs, providing various buffer products.
- First Trust Buffer ETFs: Provide typical 12-month horizon products using options.
- Pacer Swan SOS ETFs: Structured Outcome Strategies that reset quarterly.
Conclusion
Investors must consider their entire portfolio context before utilizing buffered ETFs, as emphasized by Brian Regan from Wealth Enhancement Group, who views them as beneficial within a diversified portfolio.
