2020 has become the year in which the balance between portfolio risk and reward becomes increasingly important. Fund sponsors have started offering a wide variety of actively managed ETFs, including buffered ETFs.
Also known as defined outcome, target outcome or structured ETFs, these funds can help reduce risk and lower portfolio volatility. Given the volatility of the market, investors' interest in these products is increasing as they seek growth in the stock market with reduced downside risk.
Buffered ETFs, first launched in 2018, provide a level of protection (or buffer) in down markets, while also providing capped exposure and thus limited growth in up markets.
The terminology used in fund prospectuses may seem confusing at first glance, but there are a few important points that potential investors should be aware of before adding these products to portfolios.
Let's take a closer look:
Innovator S&P 500 Buffer October ETF
Current price: $ 28.04
52 Week Range: $ 19.89 – $ 28.94
Expense Ratio: 0.79%
Innovator Capital Management was the first fund sponsor to launch buffered ETFs in 2018. The group now offers a wide range of such structured funds. Other fund sponsors also offer similar products.
Market Index
Like most other ETFs, buffered funds track the price performance of a specific index, such as the S&P 500, or. New ETFs tracking other indices regularly enter the fray.
The Innovator S&P 500 Buffer October (NYSE 🙂 tracks the index.
Outcome Period
Buffered ETFs typically track the target index for a year. This time frame is the outcome period. Fund sponsors usually list a monthly or quarterly series of these structured funds.
As its name implies, the Innovator S&P 500 Buffer October ETF, which was rearranged on October 1, is part of a monthly series of funds. For example, the Innovator S&P 500 Buffer November ETF (CBOE: BNOV) will be rebalanced on November 1.
Capped Upside Growth
These target ETFs offer capped potential profits. For the Innovator S&P 500 Buffer October ETF, the starting limit on October 1 was 18.30%.
In other words, even if the S&P 500 index doubled in value, for example, between October 1, 2020 and September 30, 2021, BOCT's maximum return would be 18.30% (minus the expense ratio of 0.79%).
Buffered ETFs can be bought or sold at any time during a trading day. However, it is important to underline that this stated ceiling level only applies when bought on the first day of rebalancing, in this case October 1.
After the new period has begun, those who buy the fund do not necessarily achieve the maximum return.
Buffered Down Loss
These funds also come with built-in protection against potential losses. The prospectus for a particular fund highlights the buffered amount above which investors suffer losses. Typically, this stated buffered amount is a percentage of the net asset value at the beginning of the one-year hatching period.
For the Innovator S&P 500 Buffer October ETF, the starting buffer on October 1 was 9%. The fund's value will therefore only decline after the underlying S&P 500 has fallen by 9%.
Included Products
To achieve its purpose, such a fund typically maintains an actively managed basket of Flexible Exchange® options (or FLEX options). These options have different strike prices and the same expiration date.
We discussed various hedging strategies or speculative bets using straight put purchases and spreads in previous articles. We also looked at ETFs that leverage their strategies.
The detailed options strategy in buffered options is beyond the scope of this article. In simple terms, fund managers come up with a strategy that is somewhat similar to a collar (but not completely). As a result, the payout structure is known when the option expires. However, how a particular ETF performs on any given day of the year is not fully known.
Finally, because the strategy uses options, investors also sacrifice the dividend yield offered by the index.
Bottom Line
Each market participant has a unique set of objectives, resources and constraints. However, given current health and economic concerns, risk management is important.
Diversification can help reduce portfolio volatility and achieve respectable returns. Buffered ETFs can also play a role in a wide variety of retail portfolios. However, their risk / return profile is different from a typical buy and hold strategy.
For example, such funds may be attractive to market participants who want to invest for a shorter period of time, such as a year or two, but are afraid of risking their capital. In such a case, another ETF, such as the Innovator S&P 500 Ultra Buffer November ETF (CBOE: UNOV), can provide greater peace of mind. The risk buffer is 30%, while the limiting limit is 8%.
Academic research and real-life market data from indices such as the S&P 500 show that buy-and-hold investors who remain invested in the market for several years or decades will not always see a greater benefit from such hedging strategies, which bring by definition always entails costs.
Defined Results funds are a relatively new concept. Investors interested in these products can view different monthly and quarterly ranges based on different indices.
If investors are not clear about the suitability of buffered funds for their portfolios, they should contact a financial planner in their respective countries. For US investors, fixed-outcome ETFs may also have other year-end tax implications.
