Buffered ETFs were first launched in the US market in 2018 and have grown in popularity by total AUM and number of ETFs ever since. Buffered ETFs were the first of what is now usually known as the “Defined Outcome ETF” family. Since simple buffered ETFs came to market other fund types have followed, such as income generating ETFs and more recently those consisting of Autocall payoffs on a regular roll schedule. In this article we will consider the original buffered ETFs which remain very popular and are the most commonly used in the market.

Introducing Buffered ETFs

Buffered ETFs all have an underlying “base” index, in a similar way that structured products do. The most popular choices are the S&P-500, Nasdaq-100 and Russell 2000, all of which have large amounts invested in the vanilla ETF versions.

This concept bridges the gap between equities and fixed income. Defined outcome ETFs represent a middle ground between the full upside potential of traditional equity investing and the capital preservation focus of fixed-income investments, helping provide downside protection and upside participation.

How They Work

Buffered ETFs are usually constructed by regular purchases on a listed exchange such as the FLEX (Flexible Exchange) Option market in the US. They are equivalent to a collared derivative structure which can be achieved in several ways such as long underlying, short call and long put option. This provides protection on the downside but accordingly limits upside in strong markets.

The first three such ETFs in 2018 were all launched by Innovator, a specialist ETF provider. They were the S&P 500 Buffer ETF – July (ticker: BJUL) with a 9% buffer, S&P 500 Power Buffer ETF – July (PJUL) with a 15% buffer and S&P 500 Ultra Buffer ETF – July (UJUL) with a 35% deep buffer. As well as Innovator, the major issuers now include FT Vest, Allianz, iShares and Alliance Bernstein.

Advantages and Limitations

Buffered ETFs give investors a predetermined formula of outcomes as a function of the underlying asset. The "buffer zone" provides investors with some protection against losses while capping returns above a specific limit. For example, a buffer ETF may cap losses at 10% during market downturns while limiting gains to 15% for positive performances. Most buffered ETFs use a 12 month option maturity, but some employ 3 or 6 months.

At each roll date, the proceeds of the options are redeemed and immediately re-invested for the next cycle. At this point option strikes are determined and the cap and buffer for the next period are published. An investor knows exactly their risk profile until the next option maturity date.

Timing risk is a critical and practical issue. For investors who do not buy at the start of an outcome period, the buffer and cap will shift on a relative basis depending on how the index moves each day. This is similar to a structured product where terms apply only to an investor buying at outset and holding to maturity. This is one of the reasons why these strategies are usually issued on monthly cycles. Fund firms want to give investors buy in opportunities throughout the year and so with monthly issuance on an annual roll cycle there will always be a fund that will have reset within the last month and therefore in most cases will have a risk profile near to the stated buffer characteristics.

All Defined Outcome ETFs are significantly different from their mainstream equivalents. The regular option strategy means that the ETF adopts non-linear return characteristics like those seen in structured products. Some actively managed ETFs may have similar rebalancing but this is in general not done in a systematic or transparent manner.

Buffered ETFs have significantly higher fee levels than mainstream ETFs, usually around 50-80 basis point per year instead of 0 to 5 basis points. This is because of the management that is required and the associated bid-ask transaction costs of the options that are traded.

The cost of executing this risk management overlay is a feature of these ETFs and therefore the benefits of the controlled risk solutions that they present need to be weighed against this fee drag. There has already been debate and analysis about whether such costs are worth it or if it is better to wear such risks or construct a reduced risk portfolio in another way.

One significant difference that buffered ETFs have compared to structured products is on each rebalance they are broadly vega neutral since the collared long put and short call position roughly cancel out. Therefore the holder of these ETFs will not significantly benefit from taking advantage of the long term differential in most markets between implied and historical volatility, known as the “volatility premium”. Selling downside risk (usually reduced by barrier protection) is one of the key features of structured products and has proven to be mostly successful over many years and underlyings. Buffered ETFs trim the upside and downside on returns and represent a tighter market and volatility neutral approach.

Buffered ETFs have proven very popular and fit a section of the market looking for transparent, liquid and targeted risk controlled solutions.