Buffered

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  By Guest Blogger Sinan Terzioglu

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Buffer ETFs, also known as defined-outcome ETFs, have gained popularity for their ability to provide some downside protection on an underlying index while still allowing participation in potential market gains. This feature makes them appealing to investors who are wary about market volatility. However, despite their initial appeal, long-term investors should avoid these products.

Buffer ETFs utilize complex options strategies to set a position that defines an outcome over the next 12 months. This outcome includes a specific threshold such as a 10% or 15% decline, which the index must fall before the ETF incurs losses. At the same time, the ETF can benefit from gains up to a certain limit, like 10% or 15%, beyond which no additional gains will be realized.

Buffered strategies are not a recent innovation as they have been used in products sold by insurance and mutual funds companies for several years. However, the ETF versions have become widely available as US and Canadian providers have introduced dozens of buffer ETFs tracking various equity indices such as the S&P 500, Nasdaq 100 and MSCI EAFE Index. Today, there are over 250 such funds, with approximately US$50 billion in assets.

The protection provided by buffer ETFs is limited and extreme market downturns can still result in substantial losses so investors need to be aware of the specific terms and conditions of each ETF, as these can vary widely. For example, if a buffer ETF provides downside protection of 15% and the underlying index drops by 35% during the outcome period, the investor could be down as much as 20%. Buffer ETFs can be traded at any time, but they need to be held for the entire one-year outcome period to function as intended.

One of the first buffer ETFs, the Innovator US Equity Buffer ETF (PAPR), was launched in April 2019. PAPR aims to define the outcome of the S&P 500 starting April 1 each year for the following 12 months, providing protection against the first 15% of downside. However, holders of PAPR sacrifice potential upside returns beyond approximately 14.50%. PAPR does not pay dividends as options are written on the price return of the S&P 500 only, not the total return. The partial downside hedge and upside cap are reset annually, so investors who purchase this ETF at any other time than the annual reset day of April 1 may have very different protection and buffer zones.

Over its initial outcome period from April 1, 2019, to March 31, 2020, the S&P 500 had a total return of -8.04%, while PAPR lost 0.73%. This period included the fastest ever 30%+ decline in global equity markets from mid-February, 2020 to March 23, 2020, due to the onset of the COVID-19 pandemic. As expected, holders of PAPR over the entire outcome period experienced less of a drawdown than the S&P 500.

However, an investor who continued to hold PAPR through the following reset period starting on April 1, 2020, and held for the next 12 months would have experienced a significant amount of underperformance relative to the S&P 500 due the cap on the upside. From April 1, 2020, to March 31, 2021, the S&P 500 returned a total of 63.79%, while PAPR returned 14.51%.

The primary drawback of buffer ETFs is their asymmetrical return profile. PAPR, for instance, protects against the first 15% of losses for the S&P 500 but caps upside returns at approximately 14.50%. This means that if an investor holds for the full one-year outcome period and the market falls 50%, they could lose up to 35.50% while the maximum gain would be less than half the potential loss. Therefore, holders of buffer ETFs are more likely to miss out on upside returns than benefit from the limited downside protection. This is evidenced by PAPRs average annual return of 7.17% since inception, which is less than half the average annual return of the S&P 500 over the same period.

In summary, while buffer ETFs can offer some protection in volatile markets, they are not suitable for long-term investors due to their complexity, limited downside protection, capped upside and higher costs.

A more effective strategy for reducing downside risk and achieving solid risk-adjusted returns over the long-term is to maintain a balanced and globally diversified portfolio, which provides a buffer without restricting the upside potential of equity holdings.

Sinan Terzioglu, CFA, CIM, is a financial advisor with Turner Investments, Private Client Group, Raymond James Ltd.  He served as vice-president of RBC Capital markets in New York City and VP with Credit Suisse in Toronto.

Source: https://www.greaterfool.ca/2024/09/24/buffered/