Buffered ETFs add ‘guard rails’ to uneasy equity market

If ever there was a product tailored to the times, it might be buffered ETFs, which are designed to limit losses in exchange for a cap on the upside gains.

Whether clients are nervous about the top-heavy nature of a historic bull market or the potential fallout from growing political unrest and the economic drag from new taxes introduced under a Democratic-controlled Washington, there is justification for a risk-off mood.

Enter buffered exchange-traded funds, which have been gaining appeal among financial advisers and clients who are ready to start locking in some gains and reducing risk.

“It’s still a relatively small market, but buffered ETFs represent one of the fastest growing products out of the gate we’ve seen in the ETF space in some time,” said Ben Johnson, global director of ETF research at Morningstar.

Originally introduced by Innovator Capital Management in August 2018, there are now five companies offering buffered ETFs, and one with products in the filing stages.

“The appeal for investors is having more control over their outcome in equity markets and having some knowledge of what the outcome will be,” said Innovator chief executive Bruce Bond.

In the buffered ETF space, it is not uncommon to hear references to things like “guard rails” that might help keep a vehicle from straying off the road.

“Baby boomers don’t want to have to go back to work or have to make money twice,” said Bond in explaining the appeal of products that can reduce investment losses if used properly. While buffered ETFs come in various flavors, and the level of creativity continues to evolve, the general idea is to use derivative instruments to mimic the performance of a broad market index, such as the S&P 500.

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For fees that start above 70 basis points, which is high compared to a basic index fund, investors get downside protection that can be structured in a variety of ways. For instance, if a fund protects the investor from the first 10% decline and the underlying index is down 11%, the investor only suffers a 1% loss.

Some buffered ETFs are structured to let the investor absorb the losses up to a certain percentage with protection kicking in to limit losses beyond that point.

In exchange for that downside protection, the funds always cap the upside in relative proportion. A specific example is the AllianzIM US Large Cap Buffer10 Jan ETF (AZAJ), which protects the first 10% on the downside and caps the gains at 13.45%.

To understand how the downside protection is tied to the upside cap, consider the AllianzIM US Large Cap Buffer20 Jan ETF (AZBJ), which has a 20% downside buffer, but caps gains at 6.91%. It is also important to understand that these ETFs, which are typically issued monthly or quarterly, are designed to be held for a full 12-month cycle to enjoy the full benefit.

“The best way to use these products is with the intention of holding them for 12 months,” said Todd Rosenbluth, director of mutual fund and ETF research at CFRA.

He also points out that, unlike a target-maturity bond ETF that shuts down at the maturity date, buffered ETFs can be held for multiple 12-month periods, but the caps are likely to be reset and adjusted based on market conditions.

Because they use derivatives to track the index, the further away from the 12-month maturity the more the fund’s performance lags the index. But it does track the index if held for the full 12 months.

“The receptivity has been astonishing, and it’s interesting to listen to advisers and how helpful it is in terms of managing risk for their clients, but education is key and that’s a big part of what we’ve been focusing on,” said Johan Grahn, head of ETF strategy at Allianz Investment Management, which entered the ETF space last year with buffered products.

Grahn compared the risk management aspects of buffered ETFs to the annuity business, an area in which Allianz manages about $150 billion worldwide. “We’re extending our several-decades old value proposition into the ETF space,” he said.

In addition to Innovator and Allianz, buffered ETFs are currently offered by First Trust, Pacer, and TrueShares. New York Life’s IndexIQ represents at least one company the has filed to launch buffered ETFs.

While the ETF wrapper is relatively new, the buffered strategy has its origins in the more expensive and less liquid structured products space.

“I like to think of buffered ETFs as structured products 2.0, and it’s a strategy that will appeal to at least half of my clients,” said Paul Schatz, president of Heritage Capital.

Schatz said he spent much of last year studying buffered ETFs to make sure they’re right for some of his clients who are closer to retirement and increasingly risk averse.

“It’s another way to skin the rat by offering some downside protection for people who aren’t worried about making 20% in a year,” he said. “I’ve got a lot of clients who don’t care about the 30% and 40% up years, they just don’t want to endure the 20% down years.”