‘Buffer’ Funds Lure Investors Seeking Protection in Market Turmoil
A small group of exchange-traded funds that purport to offer built-in protection against losses—but cap gains at a fixed level as well—has surged in popularity during this year’s stretch of heightened volatility.
Mischa Frankl-Duval • May 5, 2020
“Buffer” ETFs, which seek to protect investors against a set percentage of losses over a fixed period, have taken in about $1.9 billion so far this year, FactSet data show. That is more than the $1.49 billion they added in all of last year.
These funds, which have total assets of about $3.6 billion according to FactSet, allow investors to track the price of an underlying index such as the S&P 500 while using options to mitigate against losses. In exchange for that protection, investors’ gains are capped at a certain level.
The funds have drawbacks, though. For starters, the buffers are limited in terms of loss protection. In some, investors are only protected from the first 10% or 15% of a market drawdown depending on the fund’s terms. That means investors could still lose out if markets fall further.
Investors also forgo dividends—a big disadvantage with the S&P 500’s dividend yield at 2.07%. Fees are hefty, too, especially compared with standard tracker funds.
Innovator Capital Management LLC, for example, offers a number of buffer ETFs. These carry a 0.79% management fee, well above the 0.09% at State Street’s popular SPDR S&P 500 Trust ETF.
Still, many investors were prepared to make the trade-off when fears over the spread of the coronavirus ravaged markets. “People are really willing to give up an unknown, which is where the market will be at the end of the year, for a known, even if they have to give up, potentially, some of their upside,” said Bruce Bond, co-founder and chief executive of Innovator Capital.
Innovator’s S&P 500 funds, available in monthly series, offer different levels of protection over a one-year period. Investors can shield themselves against the first 9% or 15% of losses, or against losses greater than 5% but below 35%, depending on which fund they select. The more buffer investors want, the lower the level at which their gains are capped.
When markets are falling, buffer funds can offer some protection. The April 2019 series of Innovator’s S&P 500 Buffer ETF returned minus-0.7%, net of fees, over its initial yearlong outcome period to March 31. The S&P 500 fell 8.8% over that time.
Some investors argue the extra protection isn’t worth the added cost over the longer term because history shows diversified portfolios of stocks tend to rise over time.
Investors also have to be vigilant about the terms of the funds because the buffer and cap can differ from what is initially advertised. Both levels are calculated from the start of the outcome period, not from the date investors buy in. Those buying in partway through the yearlong period may not get the same degree of buffer, nor the same limit on their gains. “You’re really protecting first losses, and taking a lot of risk thereafter,” said Joseph Halpern, chief executive of Exceed Investments LLC, a New York-based asset manager with mutual funds that offer buffer strategies. “It’s nice to protect from the first 10%, but from top to bottom, this market dropped about 35%.”
Options-market dynamics mean the upside cap on buffer funds can vary depending on when those caps are set. When markets are more volatile, caps tend to be higher, making the fund’s terms more attractive. The terms of the April 2020 reset of Innovator’s S&P 500 Buffer ETF offered investors an initial cap of 22% and a buffer against their first 9% of losses. The February version, launched when markets were calmer, offered the same buffer, but a cap of just 13%. “These kind of structures monetize volatility, so the higher the volatility, the better the terms, which is another reason why they’re selling so well,” said Karan Sood, chief executive and managing director at Cboe Vest, which serves as a portfolio manager to a number of buffer strategies.
The February version of the First Trust Cboe Vest US Equity Deep Buffer ETF has taken in more than $425 million this year, according to FactSet, about twice as much as any other buffer ETF. It is designed to protect investors from losses between 5% and 30%, while gains are capped at 6.65% after fees and expenses. The management fee is 0.85%.
With volatility remaining elevated, Innovator’s Mr. Bond says he expects interest in buffer funds to remain strong. “We don’t know if the other leg down is coming, but people want to take advantage of the upswing, if that occurs,” said Mr. Bond. “The downturn in the market has put [the funds] on a lot of people’s radar,” he said.
Large financial institutions have long used structured notes to deliver similar results, but such strategies have been available in an ETF wrapper only since 2018. Investment advisers say buffer ETFs offer greater liquidity and lower fees than structured notes and are easier to use. “We decided at some point after a strong 2019 to implement with a portion of our portfolio a little bit of downside protection,” said Mark Andraos, associate portfolio manager at New Jersey-based Regency Wealth Management, which manages around $300 million. The firm first invested in Innovator’s ETFs in the middle of last year but decided to increase its position to $6 million as equity valuations continued climbing. “We thought it was a great way to take a few chips off the table,” he said, adding the fund provided downside protection during the selloff and performed as expected.