‘Buffers’ Expand ETF Toolbox

Defined outcome ETFs have taken root and given investors a unique way to manage risk.

[If you would like to learn more about defined outcome ETFs, please join us Thursday, Aug. 20 at 2 p.m.ET for our free webinar, “How to Hedge Market Risks with Defined Outcome ETFs.”]

One of the cool things about ETF is how they open new doors to—or, some say, democratize—the way we invest. All assets classes, a wide range of countries and many trading techniques that were out of reach for ordinary investors can now be accessed easily and cheaply through an ETF.

One such tool that has been added to the ETF investor’s toolbox is the defined outcome ETF, also referred to as “buffer ETFs,” which provides investors downside protection in a trade-off for a capped upside. Since the launch of the first defined outcome ETF in 2018, including the Innovator S&P 500 Power Buffer ETF – October (POCT), in October 2018, the space has seen more than $4.4 billion in assets go into what now has grown into more than 60 such funds being offered by four issuers, with more in the filing pipeline.

There is clearly growing interest in this kind of fund and how it fits into a portfolio or asset allocation strategy. Innovator was first to market, and the success of its first launches was followed by the First Trust CBOE Vest suite of buffer products that aim to do the same thing, but in a slightly different way when it comes to cap percentages.

Forsaking Upside For Downside Protection

With stocks climbing to new all-time highs seemingly every month, and the pandemic uncertainty looming over markets, many investors have come to embrace the idea of giving up some gains to protect against losses. And with what we saw in March and April as stocks cratered only to establish a record rebound, trying to the time the markets has been mere folly.

The concept is simple, but each defined outcome structures is different in terms of the downsize protection and upside cap, depending on the issuer and the particular product. Investors should understand what their downside and upside caps are in addition to the other details they would be concerned with for any conventional ETF.

We have seen these “buffers” in action recently during the market mayhem in March when stocks were plunging. As the chart reflects, the downside protection mitigated losses, as designed. Here is a chart comparing POCT and the SPDR S&P 500 ETF Trust (SPY):

Courtesy StockCharts.com

The chart clearly reflects that during the significant market downturn in mid-March, the “buffer ETF” mitigated the losses SPY experienced, and on the flip side, as stocks bounced back in record time, POCT did not capture the total upside. Year to date, SPY is ahead of POCT by 147 basis points, but in the March meltdown, POCT experienced half the loss SPY did. Forsaking some upside for that downside protection played out exactly as designed.

Evolution Of Defined Outcome ETFs

To date, the existing buffer ETFs have covered equities of all types, but the thesis is versatile, and Innovator has filed for similar products covering the fixed income market. In theory, the defined outcome thesis could have wide application for those seeking risk management. What will be interesting to watch is if the investors who use the defined outcome ETF products in the equity space will seek the same in fixed income.

And in another evolutionary step for this type of ETF, both Innovator and FT CBOE Vest have just this week launched laddered buffer ETFs, which hold other defined outcome ETFs.

While the FT Cboe Vest Fund of Buffer ETF (BUFR) is a brand new fund, the Innovator Laddered Fund of S&P 500 Power Buffer ETF (BUFF) is a renovation of the Lunt Low Vol/High Beta Tactical ETF (LVHB) with a new name, ticker and index.

BUFR comes with an expense ratio of 1.05%, and BUFF charges a total expense ratio of 0.99%. 

“BUFF will seek to offer investors a managed portfolio (an ETF of ETFs) that will invest equally across all twelve monthly S&P 500 Power Buffer ETFs—providing a ladder of buffered S&P 500 exposures,” Innovator said this week. “The twelve underlying buffered S&P 500 exposures each have a different upside cap level and period of time until their annual reset, but share a 15% buffer against losses in the S&P 500 Index over their outcome period.”

ETF Toolbox Getting Heavier

Defined outcome ETFs are not a passing fad, and the expectations of more issuers offering an easy-to-use, reasonably priced risk management tool such as these is high. As we have seen over the last 10 years with fixed income ETFs, when the snowball gets rolling, it becomes bigger and bigger at a quicker pace.

Thanks to innovation on the issuer side, we continue to see so many new ways that the ETF wrapper can be used to help advisors and investors achieve investment goals. It’s just another example of how ETFs have democratized investment ideas and approaches previously exclusive to institutional or high net worth investors.

[If you would like to learn more about defined outcome ETF, please join us Thursday, Aug. 20 at 2 p.m.ET for our free webinar, “How to Hedge Market Risks with Defined Outcome ETFs.”]

Drew Voros can be reached at [email protected]