Buffer ETFs Require Precise Financial Advice

Buffer ETFs continue flying off the shelves as the go-to product for financial advisors trying to keep nervous clients fully invested.

But as the ETF category has ballooned to $36.7 billion (from less than $200 million in 2018, according to Morningstar), it's worth asking whether these complex and higher-cost products are appropriate for all clients.

The basic concept of the strategy, which is also known as defined outcome, is that they use equity options to replicate the performance of a benchmark. At the same time they offer downside protection in exchange for an upside cap.

Key to this protection, like the structured products they are modeled after, is specific life cycles, typically 12 months, offered monthly or quarterly.

For example, a buffer ETF with a lifecycle from March 1, 2024 through Feb. 28, 2025 might limit losses to 10% over the 12-month period and cap upside at 15%. This might suit some investors perfectly, unless that particular ETF is purchased at the end of March or later after the market has already experienced a strong rally or declined below the buffer.

Point is, advisors can buy buffer ETFs at any point during their lifecycle, but buying in without factoring in market conditions can eliminate the value of the buffer the investor is paying for.

For advisors rebalancing or dollar-cost-averaging across client portfolios and otherwise investing new money on behalf of clients, the buffer ETFs might not be the best underlying strategy.

Buffer ETFs Come With Planning Challenges

“There are a lot of variables to consider, including the starting cap and buffer level, the remaining cap and buffer, the outcome period, how much of the period has gone by, the level of the reference asset and where the actual buffer fund is trading,” said Jeff Schwartz, president at the investment analytics firm Markov Processes International.

“There is a lot to understand with buffer ETFs, and the history of structured products shows that both advisors and investors often do not fully understand the nuance of these vehicles," he said.

Even if the market hasn’t risen past the cap or below the downside protection level, any market movement up or down alters the potential outcome of a buffer ETF that is purchased at any point beyond the start date.

But this will happen when advisors allocate clients into a year’s worth of monthly buffer ETFs and then add new money to those ETFs throughout the year.

Morningstar analyst Lan Anh Tran said investing in buffer ETFs after the start date is “not the ideal way to buy into those funds.”

“The biggest concern is missing out on things, because if the market has gone up past a cap, you won’t get that performance from where you buy in,” she added.