Recent downturns from the Great Recession and the worldwide pandemic are still fresh on investors’ minds. Now any pullback in the market has left investors shaky. Earlier this week, the VIX fear gauge reached the highest level since the pandemic, which caused some investors to consider pulling out of the market. But rather than sit in the sidelines, cautious investors can look at defined outcome ETFs, which limit some downside in exchange for giving up some upside in a given reference investment (typically the S&P 500). The most common type of defined outcome ETF is a buffer ETF which has gathered significant interest in a short period of time. This is a brief analysis of buffer ETFs, the current market of defined outcome ETFs, and pros/cons for investors.
What are buffer ETFs?
To understand how buffer ETFs work, you need to have at least a high-level understanding of options. While options seem intimidating to some investors, buffer ETFs are less complicated than they seem.
A straightforward one to start with is the Innovator U.S. Equity Power Buffer ETF (PJAN). It is one of the most popular buffer ETFs. This fund provides exposure to the SPDR S&P 500 ETF Trust (SPY). It has a starting buffer of 15% and a starting cap of 14.2%. This means the ETF is protected against the first 15% of losses. But in exchange, it can only make a 14.2% maximum return.
PJAN is meant to be held for the outcome period of January 1 to December 31 and resets each year. Buying intra-period is possible. However, you would have a different cap and buffer than at the beginning of the period. (Details and instructions to find the intra-period cap/buffer are on the ETF’s website.)
The ETF holds four SPY options. These are Flexible Exchange (FLEX) options which allow for customization.
- Long deep-in-the-money call: provides equity exposure
- Long put with higher strike price and short put with lower strike price (put spread): provides downside buffer
- Short out-of-the-money call: covers cost of buffer and creates upside cap
Buffer ETFs are about the buffer—not the return
Buffer ETFs are most attractive in uncertain markets. But as we know, it is difficult to time the market. This chart shows how PJAN has performed against the S&P 500 each year. In a year like 2022, PJAN fell 5%, while the S&P 500 fell close to 20%. But in every other recent year, PJAN underperformed. If an investor used PJAN as a core equity replacement, they would have missed out on several years of returns.
This isn’t a surprise, because in most years, the S&P 500 does relatively well. But buffer ETFs aren’t meant to completely replace core equity holdings. Nor are they meant to generate alpha. These are used to gain some participation with less volatility and a greater return/risk profile.
Investors can instead use these ETFs in conjunction with their core equity holdings to manage some risk. Some investors may also use these to replace a portion of their fixed income or cash holdings. However, buffer ETFs are generally riskier than these investments since they decline along with the reference asset (but to a lesser extent).
The market for buffer ETFs and defined outcome ETFs continues growing
The market for defined outcome ETFs has grown significantly over the past six years. In August 2018, Innovator released its first set of buffer ETFs, followed by First Trust/Vest Financial (FT Vest) in 2019. The list of issuers grew to include large issuers like Fidelity and iShares, but Innovator and FT Vest remain the leaders in the segment.
These products grew to include ETFs that track a variety of reference assets besides the S&P 500, including international equities, small-cap equities, fixed income, and gold. The types of defined outcome ETFs expanded to other areas like defined income, accelerated, and even 100% downside protection buffers like the Innovator Equity Defined Protection ETF – 2 Yr to July 2025 (TJUL).
Laddered products like the FT Vest Laddered Buffer ETF (BUFR) are also popular, as they create a ladder of 12 monthly buffer ETFs that smooths timing risk. In total, the defined outcome universe now contains around 300 funds with over $50 billion in assets.
Bottom Line
YTD, these ETFs have seen over $9 billion in net inflows. And the number of funds has almost doubled over the past year. I believe there will be continued interest in these products, as many investors have grown risk-averse due to a combination of recency bias and an overvalued equity market.
Diversification into bonds, commodities, and other low-correlation investments are typically the best ways to protect yourself against equity market downturns. But buffer and defined outcome ETFs still have a place in risk-averse portfolios as a supplement to core equity and fixed income holdings.
Listen here to a discussion on defined outcome and buffer ETFs.
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