Buffer ETFs Surge to $36.9B, Offer Loss Protection with Caps

Key Takeaway

• Buffer ETFs, growing to $36.9 billion in assets, offer market loss protection at the cost of capping potential returns.
• Innovator leads in defined-outcome ETF space; Calamos introduces products with 100% downside protection and specific upside caps.
• Investors must weigh downside protection against higher fees (~0.75%-0.80%) and potential missed market gains.

Buffer ETFs Gain Popularity

Investors seeking protection against market downturns are increasingly turning to buffer exchange-traded funds (ETFs), also known as defined-outcome ETFs. These funds, which utilize option contracts to mitigate losses, have seen their assets grow from approximately $183 million at the end of December 2018 to $36.9 billion by April 2024, according to Morningstar. Lan Anh Tran, a manager research analyst at Morningstar, highlighted the trade-off inherent in these products: protection against downside comes at the expense of capping the upside potential. This growing interest is particularly pronounced among investors nearing or in retirement, aiming to preserve capital against market volatility.

Understanding Buffer ETFs

Buffer ETFs employ a sophisticated strategy involving three layers of options to provide a defined buffer against losses while capping gains beyond a certain point. For example, a fund might protect against the first 10% of an index’s loss but limit returns past a 15% gain. Innovator Capital Management was among the pioneers in this space, launching its first defined-outcome ETF in 2018. Competitors such as PGIM, Allianz, and BlackRock have since entered the market, with Calamos introducing a new line of ETFs offering 100% downside protection and a 9.81% upside cap rate. These ETFs appeal to investors looking for tax efficiency and protection against market downturns without sacrificing potential growth.

Investment Considerations

Before investing in buffer ETFs, individuals must assess their desired level of downside protection, which directly impacts the upside cap. Timing is crucial, as the full benefit of these ETFs is realized if held from the start to the end of the options' expiration period, typically one year. However, products like the JPMorgan Hedged Equity Laddered Overlay ETF offer more flexibility without specific loss thresholds or upside caps. Potential investors should also weigh the opportunity cost of missing out on higher market gains and consider the higher fees associated with buffer ETFs, which average around 0.75% to 0.80%.

Street Views

• Lan Anh Tran, Morningstar (Neutral on buffer ETFs):

  "That downside protection … is coming at the cost of giving up some of the upside of the index. That’s the kind of trade off and promise that these products offer."

• Todd Sohn, Strategas Securities (Bullish on buffer ETFs for certain investors):

  "Most of those investors lived through the tech bubble and financial crisis and they think they cannot risk the possibility, however slim, of another meltdown." "It is just a packaged solution of a really complex investment strategy that is really efficient for a lot of people out there... I think it will get bigger and bigger as time goes on."

Management Quotes

• Matt Kaufman, head of ETFs at Calamos:

  "This is a tax efficiency play... Whereas here, you can leave your money in and allow it to grow. If you want to take income off of that, you can pay yourself off of that capital appreciation."