Buffer ETFs can turn volatility into a better client conversation

For many clients, the hardest part of investing is not accepting that markets go up and down. Rather it is staying invested when the next downturn feels imminent, valuations seem high and the traditional stock-bond mix does not feel as dependable as it once did.

That is why buffer ETFs have moved from a niche category to a staple portfolio construction tool. What began largely as a way to help retirees, pre-retirees and risk-conscious investors stay invested through volatility is evolving into a wider toolkit, with defined outcome structures applied across different reference assets, protection levels and growth-oriented objectives. Younger clients may not need the same protection as retirees, but they may still benefit from a more intentional way to participate in markets.

A buffer ETF, part of the defined outcome ETF category, typically tracks a reference asset such as the S&P 500, Nasdaq-100 or Russell 2000. It seeks to provide participation in that asset’s gains up to a predetermined cap, while also seeking to protect against a defined level of initial losses over an outcome period, typically 3, 6 or 12 months.

The defined outcome structure changes the client conversation. Instead of asking a nervous investor to simply “stay the course,” an advisor can explain the range of potential outcomes more clearly. If the reference asset rises, the client can participate in the gains up to the cap. If the reference asset falls within the buffer, the ETF is designed to protect against the loss. If the reference asset’s loss exceeds the buffer level at the end of the outcome period, the client can lose money.

Just as important, investment tradeoffs can be tied directly to the client’s individual objectives. An advisor can explain why a buffer ETF is being used in a portfolio, what the client is giving up, what protection they are receiving and how the strategy fits their broader plan. That level of clarity can make the portfolio feel more customized and, in my experience, strengthen trust between the advisor and client.

To be clear, the buffer is not a guarantee against all losses, but rather a defined level of downside protection over a specific period, and the client needs to understand where that protection begins and ends.

The cost of the protection is the upside cap. In a strong bull market, an investor in a conventional buffer ETF may underperform the underlying reference asset because gains above the cap are forfeited. That is acceptable because that is the tradeoff for having a level of protection in place. The advisor’s job is to determine whether it fits the client’s goals, time horizon and temperament.

Buffer ETFs can be particularly useful for clients holding too much cash because they are worried about re-entering the market at the wrong time. These ETFs offer a measured way to put cash to work, with downside protection and enough upside potential to make the allocation worthwhile.

The ETF wrapper is another reason advisors are paying attention. Unlike many structured products or annuities, buffer ETFs trade throughout the day, have no surrender charges and do not require a multi-year lockup. They also provide transparency into the reference asset, buffer, cap and remaining outcome period.

That transparency is crucial because buffer ETFs come with varying structures and outcome parameters. Advisors should be particularly careful when buying during the intra-outcome period (any day other than the reset date). The cap and buffer available at the start of the outcome period may no longer apply. If the reference asset has already appreciated since the most recent reset date, there may be limited upside remaining and there could be significant “downside-before-buffer risk” before the protection kicks in. And, if the reference asset has fallen, part of the buffer may already be used up.

Common approaches include buying at the start of the outcome period and holding through the reset, laddering ETFs with different reset dates, or rotating when an existing position has used up much of its cap or buffer. The more active the approach, the more complexity, tax considerations and monitoring it can require.

As always, the right approach starts with the individual client. Advisors should ask: What level of loss would make this client uncomfortable or cause them to make a bad decision (abandon the strategy)? How much upside is the client willing to give up for protection? How long can the client remain invested? Does the client understand that the ETF can still lose money?

The real benefit of buffer ETFs may be behavioral as much as mathematical. A client who understands the downside range and upside limit is often better prepared to stay invested through volatility.

Buffer ETFs are not appropriate for every investor or market environment. For example, a young investor with a multi-decade time horizon may not want to cap upside in a long-term growth allocation. An aggressive investor willing to tolerate deep drawdowns may prefer unhedged equities. And when markets are already deeply depressed, capping a potential rebound may not be wise.

But for clients who want to remain invested without absorbing the full emotional and monetary impact of volatility, buffer ETFs deserve a place in the advisor toolkit. Used thoughtfully, they can help clients better understand the potential outcomes in their portfolio and strengthen the conversations that build trust between advisors and clients.

Stuart Chaussée is managing director, senior wealth advisor at Lido Advisors.