What You Need to Know
- Such products limit both potential downside losses and upside gains.
- In July, 289 defined outcome ETFs totaling $41.4 billion in net assets traded in U.S. markets,
- Innovator and First Trust are the top two buffer ETF providers by assets, according to Morningstar.
Many investors undoubtedly experienced panic-driven adrenaline rushes Monday as U.S. stocks sold off sharply, with the S&P 500 experiencing its biggest drop in almost two years.
Even though the index managed a strong rally Thursday, clients aiming to avoid the stress associated with heart-pumping sell-offs may be interested or already in buffer exchange-traded funds, which limit both potential downside losses and upside gains.
“Buffer ETFs can add ballast to a portfolio. Over the past couple weeks, buffer ETFs have been tested with significant volatility,” Rachel Aguirre, U.S. head for iShares products at BlackRock, told me by email Friday.
“These products are delivering a way for investors to step out of cash in their portfolios, providing access to equity growth up to a return cap, while protecting against market drawdowns,” she said.
BlackRock recently announced a series of buffer ETFs, among the latest addition to an expanding universe of such funds, which have surged in recent years.
On a Tear
In July, 289 buffer, or “defined outcome,” ETFs totaling $41.4 billion in net assets traded in U.S. markets, according to Morningstar data. That compares with 221 ETFs and $34.1 billion in assets in January, and 150 funds with nearly $14.3 billion in July 2022.
In August 2019, there were only 23 buffer ETFs with nearly $1.3 billion in assets, Morningstar reports.
The growth in buffer ETFs isn’t just a recent phenomenon, although it’s certainly received more headlines in the wake of market volatility, Zachary Evens, Morningstar Research Services manager research analyst, told me Thursday. The growth since 2022 has been driven partly by higher interest rates, he said.
“The fund managers are able to offer a cap and buffer” that’s appealing to investors,” Evens explained.
“The market volatility in 2022 brought a lot of investors into this space as they saw their portfolios drop by 20%, maybe even 30% that year, where these products offer them a relatively defined range of outcomes,” Evens added.
The Secret Sauce
For investors with a short time horizon or who are risk averse, buffer ETFs are fairly effective at reducing equity market risk while retaining some stock exposure, he noted.
These funds typically take a long position in a broad index-based fund like the SPDR S&P 500 fund, and also buy and sell options to protect investors from losses up to a certain point, he explained.
In simple terms, a buffer ETF advertising a 10% downside buffer would result in only a 5% loss for investors if the market dropped by 15%, assuming they hold the fund throughout the designated outcome period.