Executive Summary
Buffer ETFs offer a strategic option for investors seeking to balance risk and reward, particularly in volatile markets. Buffer ETFs are specialized exchange traded funds designed to provide investors with downside protection while capping potential gains. They achieve this by investing in a stock market index, such as the S&P 500, and utilizing options strategies to safeguard against losses. For instance, a “100% Buffer” ETF offers full protection against losses while limiting upside gains to a predetermined cap, currently around 8% to 10%. These ETFs allow for daily trading, and any gains realized after a year are taxed at lower long-term capital gains rates.
Introduced by Innovator Funds in 2018, Buffer ETFs come in several categories, including the 100% Buffer, Deep Protection Buffer, Uncapped Buffer, and Quarterly Buffer, each offering varying levels of downside protection and upside caps. The 100% Buffer and the Quarterly Buffer offer the most downside protection while the Uncapped Buffer provides the most potential upside. Buffer ETFs allow investors to participate in potential stock market gains with some level of downside protection.
Buffer ETFs are specialized exchange traded funds designed to provide investors with downside protection while capping potential gains. This article will explain how Buffer ETFs work, the different categories of Buffer ETFs, pros and cons of Buffer ETFs, and how to use Buffer ETFs in your portfolio.
How Buffer ETFs Work
A Buffer ETF offers limited upside participation in a stock market index, like the S&P 500, while also providing some protection in the event of a market downturn. The protection comes from option strategies used by the ETF. Here is an example based on a type of Buffer known as a “100% Buffer” offered by Blackrock – the ETF invests in the S&P 500 for a year with a cap on the upside (net of a 0.50% expense) of 10%. The investment amount is protected 100%. (Buffer ETFs have a management fee of 0.50% to 0.77%. This fee is taken out of your investment even if there is a loss in the index.) If the S&P 500 increases 20% that year, your gain is limited to 10%. If the S&P 500 increases 6%, you make 5.50%. On the other hand, if the S&P 500 loses 10% or 20% or 50%, you lose only the expense, 0.50%. At the end of a year, the ETF resets with a new upside cap. Any gains you have made are locked in. You can hold the investment or sell it.
The concept of upside participation in the stock market with downside protection is not new. Insurance companies offer this with fixed index annuities, and banks offer index CD’s. What makes Buffer ETFs different is the ETF structure. With an ETF you can buy or sell every day while banks and insurance companies lock you into a multi-year contract. An ETF has no taxable gain until you sell. If you hold the ETF for a year, any gain when you sell is long-term capital gain which is taxed at a lower rate than ordinary income. The bank and insurance products generate ordinary income. We think the ETF approach is also less costly and complex than the bank and insurance products.
Categories of Buffer ETFs
Buffer ETFs were first offered as an investment by a company named Innovator Funds in 2018. Since then, many other companies have developed their own Buffer ETF strategies including Calamos, Allianz, Prudential, and Blackrock. Currently, there are four main categories of Buffer ETFs. Described below is the current configuration for these Buffers. Caps, spreads and downside protection could change in the future:
The 100% Buffer – as mentioned above, this Buffer provides participation in the gains of an index (normally the S&P 500) subject to a cap, and provides 100% downside protection. The outcome period of the ETF holdings is normally one year.
The Deep Protection Buffer – provides downside protection of the first 15% or 20% of losses with an upside cap of 11% to 13%. The duration of the ETF holdings is normally one year. For example, a Buffer with 15% downside protection and a net cap on gains of 13% would have gains or losses (net of expenses of 0.50%) based on the index return as follows:
Index Return | Your Return |
---|---|
25% | 13% |
10% | 9.5% |
-12% | -0.50% |
-20% | -5.50% |
The Uncapped Buffer – lets you participate in all of the gains of the index for a year with downside protection of 15%. However, there is a cost for the uncapped upside called a “spread”. The spread takes the first 4% to 5% of gains away from you (there is no spread cost for a loss). So, if there is a loss in the index of up to 15%, you keep your full investment. If the spread is 5%, and there is a gain of 5%, you get -0- gain. If there is a gain of 25%, you get a 20% gain.
The Quarterly Buffer – resets the cap each quarter versus a one year time period. The downside protection is 20% per quarter. The upside cap is currently 2.5% to 3% per quarter.
Pros and Cons of Buffer ETFs
Pros
- Buffers can significantly reduce the risk of loss in your portfolio.
- If you hold the Buffer for more than a year, you are taxed at lower long-term capital gain rates when you sell.
- You could use a conservative Buffer as a bond replacement and potentially make higher returns than bonds with little downside risk. Your after-tax return could be significantly higher than bond interest.
- If you have cash on the sidelines, you could invest in a conservative Buffer and potentially get some portion of upside market returns with minimal risk of loss.
- Like any ETF, you can sell a Buffer at any time for its current market price.
Cons
- In a strong up market, the conservative Buffers will return less than equity funds.
- In order to get the maximum Buffer return, you generally have to buy a Buffer on the first trading day of the outcome period.
- The management fee percentage for Buffer ETFs can exceed the percentage on index funds.
- Over long periods of time, if the stock market has substantial gains, Buffers could underperform and the benefit of downside protection could be lost.
- Most Buffer ETFs do not pay dividends on the index in which they invest.
Comparisons of Buffer ETFs with the S&P 500 for Two Five Year Periods
In the table below, I used the current Buffer configurations and applied them to the returns of the S&P 500 for the years 2005 to 2009 and 2019 to 2023. Expenses of the Buffer ETFs were not taken into account. I chose these five year periods because the S&P 500 had a loss year in year four in both cases, but the index and Buffer total results are very different.
100% Buffer | Deep Protection | Uncapped | Quarterly | |
---|---|---|---|---|
Downside protection | 100% | 15% | 155% | 20% |
Upside cap | 9% | 13% | Unlimited | 2.50% |
Spread | NA | NA | 5% | NA |
Reset time period | Annually | Annually | Annually | Quarterly |
2005-2009 Total Return | ||||
S&P 500 return | 2.1% | 2.10% | 2.10% | 2.10% |
Buffer return | 31.50% | 10.20% | 5.50% | 27.00% |
Bond Index return (AGG) | 27.40% | 27.40% | 27.40% | 27.40% |
2019-2023 Total Return | ||||
S&P 500 return | 107.20% | 107.20% | 107.20% | 107.20% |
Buffer return | 41.20% | 58.00% | 108.50% | 39.00% |
Bond Index return (AGG) | 5.60% | 5.60% | 5.60% | 5.60% |
This comparison of the S&P 500 with the Buffers is not realistic because over time, the Buffer configurations would change . The purpose of the analysis is to show you how different the Buffer results could be based on the S&P 500 returns. Here are some observations of the analysis:
- Both of the periods above had a loss in year four – a 2008 loss of 37% and a 2022 loss of 18.1%. The returns for the first three years in each period differed greatly. The years 2005 to 2007 had one of the lowest three year returns (28.16%) in the last 54 years of the S&P 500. In contrast, the years 2019 to 2021 had one of the strongest three year returns (100.4%) in the last 54 years.
- In the 2005-2009 period, all of the Buffers beat the S&P 500 total return, but the conservative Buffers (#’s 1 and 4) returned a lot more than the aggressive Buffers. The conservative Buffers also had similar returns to the bond index.
- In the 2019-2023 period, the conservative Buffers returned much less than the S&P 500. The uncapped Buffer was the only Buffer whose return was close to the S&P 500. Note, however, that all the Buffers dramatically outperformed the bond index.
- There are several key observations you could take away from this analysis:
- The conservative Buffers seem to do well compared to the bond index over time.
- In a strong up market, we think the uncapped Buffer will return more than the other types of Buffers, but in a weak market, the uncapped Buffer will do poorly.
- It makes sense to use multiple types of Buffers and diversify your potential results.
How to use Buffer ETFs in Your Portfolio
As we have discussed above, the 100% Buffer and the Quarterly reset Buffer are more conservative and provide more downside protection. In a strong bull market, the uncapped Buffer provides the most potential upside. Depending on your risk tolerance and stage in life, here are some possible ways to use Buffer ETFs in your portfolio:
- If you are very conservative in your risk tolerance, you could use the conservative Buffers to increase your equity exposure. This has the potential to give you higher returns than bonds or cash with downside protection.
- If you are in or near retirement, you could use both the conservative Buffers and the more aggressive Buffers to partially replace bond and equity funds. While this may produce lower equity returns, your bond returns could be higher. We think you will have partially reduced the risk of loss with a similar overall return in your portfolio.
- If you are younger, or more aggressive in your risk tolerance, consider only using the conservative Buffers as a bond substitute. This could increase your bond returns over time. Do not reduce or inhibit your equity exposure by using the more aggressive Buffers.
Disclosures
The opinions expressed are those of NBZ Investment Advisors, LLC (“NBZ”). The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Forward-looking statements cannot be guaranteed. This document may contain certain information that constitutes “forward-looking statements” which can be identified by the use of forward-looking terminology such as “may,” “expect,” “will,” “hope,” “forecast,” “intend,” “target,” “believe,” and/or comparable terminology. No assurance, representation, or warranty is made by any person that any of NBZ’s assumptions, expectations, objectives, and/or goals will be achieved. Nothing contained in this document may be relied upon as a guarantee, promise, assurance, or representation as to the future.
The sample analysis shown in the table above is for illustrative purposes only and should not be interpreted as actual performance of NBZ. The analysis should not be considered a guarantee of a certain level of performance.
This is not a recommendation to buy or sell a particular security or sector. Information presented herein has been obtained from sources believed to be reliable, but NBZ does not warrant its completeness or accuracy. Figures, opinions and estimates reflect NBZ’s judgment on the date hereof and are subject to change at any time without notice. Projections are not guaranteed and may vary significantly.
The S&P 500 Index is the Standard & Poor’s Composite Index and is widely regarded as a single gauge of large cap U.S. equities. It is market cap weighted and includes 500 leading companies, capturing approximately 80% coverage of available market capitalization. The Bloomberg U.S. Aggregate Bond Index (AGG) is a broad base, market capitalization-weighted bond market index representing intermediate term investment grade bonds traded in the United States. The Index is frequently used as a stand-in for measuring the performance of the U.S. bond market. In addition to investment grade corporate debt, the Index tracks government debt, mortgage-backed securities (MBS) and asset-backed securities (ABS) to simulate the universe of investable bonds that meet certain criteria. In order to be included in the Index, bonds must be of investment grade or higher, have an outstanding par value of at least $100 million and have at least one year until maturity. The volatility (beta) of an account may be greater or less than its respective benchmark. It is not possible to invest directly in an index.
NBZ is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about NBZ’s investment advisory services can be found in its Form ADV Part 2, which is available at nbzinvest.com or by calling (865) 584-1184. NBZ-24-03.