As economists continue to predict another year of tumult in the markets, buffer ETFs are emerging as an option for those who want a more predictable return on equity exposure. These ETFs, sometimes called “defined outcome” ETFs, buy and sell long-dated call and put options on an index to limit how much losses or gains the fund produces. VettaFi’s Dave Nadig goes into more detail on the financial plumbing here.
VettaFi contributor Dan Mika spoke with AllianzIM ETF Head Johan Grahn on the asset class use cases heading into 2023.
[The following conversation has been edited for clarity.]
Johan Grahn, AllianzIM: Advisors will use a buffer just to de-risk an equity play, or they will use it to supplement or replace a significant portion of their fixed income allocation or use it as an allocation within their alternatives. One use case that’s really relevant today is to help investors that are sitting on cash to get back into the market without jumping all the way yet. Most investors are still in that conundrum of, if they have cash, they don’t really like the idea of getting into the bond market, and they’re also too worried about getting into the equity markets. You can buy a buffer ETF and get some equity exposure. If you have a 20% buffer underneath you, most investors today would find it relatively unlikely or highly unlikely that the market is going to drop at 20% or more over the next 12 months. It feels like the right time for many advisors and investors to jump into these types of products.
The other part of this, too, is that if you want to have a chance to beat inflation, that chance goes up if you’re in the equity markets. If you’re in the fixed-income markets today, it’s very hard to beat inflation. That’s another one of the arguments for why these products are so attractive right now. It gives advisors and their clients the opportunity to maintain or even build more wealth in this type of market environment.
Dan Mika, VettaFi: What are the broader recommendations you and Allianz are making to advisors and investors heading into 2023 with all the potential continued turmoil in the markets? What overall strategy are you recommending people look at heading into the year?
Grahn: It’s about being able to invest with more confidence. If you have concerns about a recession, or if you have concerns about valuations being a little bit high, or if you have concerns around the Fed continuing to take a hawkish stance, then it makes it just as difficult as 2022 to figure out where you want to place your assets. From our point of view, if you are concerned that equity markets might be selling off, then it’s obviously a good idea to build some risk mitigation into your portfolio. But on the other hand, if you’re if you’re wrong, and we would all like to hope the markets recover and come back, then you can still participate in some of that upside.
That’s where a buffer ETF fits very nice because you have that level of buffer… if the S&P 500 is down by 10% for one of our products or 20% in the case of another one of our products. It still allows you to participate in some of the upside if the markets continue to go up. In terms of how much you can participate, if you think about the longer-term predictions or return expectations for the S&P 500, they range pretty widely. From Allianz’s point of view, we’re looking at returns for 2023 between -5% and 10%. Most of the banks will put the expectation for nominal returns, call it 10% for a year on average. So if you invest in one of our buffer ETFs with a 10% buffer, you can still collect if the market goes up, you don’t get capped out until north of 20%. In the case of the 20% buffer that we have, you don’t get capped out until you hit well beyond 10%. So you can still make good returns and still, at the same time, have a nice safety net underneath your allocation.
VettaFi: What conversations do you think advisors should be having with their clients about how much percentage of a portfolio they should be tilting into into a buffer strategy this year?
Grahn: It comes down to portfolio construction and risk-return expectation based on the client profile. Suppose you think about people who are closing in on retirement or in retirement and have a slightly lower risk appetite than other investors. In that case, it makes sense to have whatever can provide that comfortable risk-return tradeoff in their portfolio. That’s where your question comes in: how much would you want to buy or invest into a buffer ETF? The short answer is that you would have to invest enough to make it meaningful. That could be whatever you’re comfortable with. If you were planning on moving 10% from equities into fixed income, for example, then perhaps you think about that a little bit differently, given the current market environment. Perhaps you take that 10% and move it into buffered ETFs instead of fixed income. On the flip side of that, if you already have moved into fixed income and you feel like that may not provide enough return to get you over the inflation hurdle, then you may want to move some of your assets on the fixed income side into a buffer ETF.
We see a lot of advisors make that recommendation to clients by moving from fixed income into our Buffer 20. That gives you a 20% buffer to the S&P 500 and well north of 10% upside participation if the equity markets go up. That’s the trade we see very frequently. In terms of tracking the S&P 500, all of our buffer ETFs are tracking the SPDR S&P 500 ETF (SPY). The reality of what type of index tracking you’re looking for really comes down to the dominant allocation in your portfolio. You might have allocations to other indices, as most investors do, but the reality is that when you really need the risk mitigation strategy in your portfolio since correlations tend to go to one, and everything is selling off at the same time. The argument for why we have SPY only in our lineup is pretty straightforward: that is where you get the risk mitigation to the magnitude that you need it in your portfolio. You can take a big allocation without sacrificing your core S&P 500 exposure.
VettaFi: When do you think it would not make sense or would not be a good fit to use buffer ETFs in a portfolio?
Grahn: it doesn’t make sense to use buffered ETFs if you’re looking to hit the ball out of the park if you’re looking for the highest possible return, if you’re 100% risk-on. These products are not built for that purpose. They’re built for risk mitigation purposes. It’s built for individuals that are more interested in capital preservation, as opposed to looking to just generate the highest possible return… It’s for individuals who have already created that wealth and want to keep it.