Home etftrends.com An Advisors’ Guide to Buffered/Defined Outcome ETFs

An Advisors’ Guide to Buffered/Defined Outcome ETFs

Buffered ETFs, which promise investors some downside protection when markets fall, have been around for a few years now.

Also known as defined outcome or structured outcome ETFs, these funds experienced a real-world test in the first quarter of 2020, when the coronavirus pandemic slammed markets and shuttered the global economy. Financial advisors who used these ETFs at the time say they worked exactly as the advisors expected, allowing them to re-assure skittish clients during the worst of the market rout.

These ETFs are easier and cheaper to use than more complex downside protection vehicles such as structured notes, the advisors say; however, they note these funds cost more than simpler downside protection ETFs (such as low volatility strategies) and take a more hands-on approach.

FLEX Options for Flexible Protection

The first buffered ETFs were launched by Innovator in 2018. Now, however, there are over 100 defined outcome products, offered by several competing firms, including First Trust, AllianzIM, Pacer, and TrueMark.

Exactly how each firm creates the downside protection varies, but these five issuers use Flexible Exchange options, known as FLEX options, to limit their losses. FLEX options allow the fund creator to customize equity or index contracts to tailor contract terms and give issuers expanded position limits for exchange-listed equity and index options.

Most defined outcome ETFs use FLEX options based on either the S&P Price Return Index or the SPDR S&P 500 Trust ETF (SPY) (though other indexes are now available, such as the Nasdaq-100 or MSCI EAFE Index). The funds are designed to be held for a full 12-month cycle, and as such will reset their exposures once the 12 months are up (although, like all ETFs, buyers can sell defined outcome funds at any time, even before the reset date).

During these twelve months, the fund will protect against some prescribed quantity of losses. For example, the Innovator S&P 500 Power Buffer ETF (PAPR) protects against losses up to 15%, while the FT Cboe Vest U.S. Equity Deep Buffer ETF (DAPR) protects against losses between 5-30% over the outcome period.

For most issuers, this downside protection also comes with an upside cap on returns of the associated benchmark; PAPR caps gains at 8.55%, for example, while DAPR caps at 7.50%. Meaning, the S&P 500 Index might move higher, but PAPR would provide a 8.55% return at most, while DAPR would provide 7.50%. The one exception here is TrueMark, whose products have no upside cap.

After the 12 months, advisors can either buy a new buffered ETF, or continue to hold the same fund, as it resets to reflect current market levels. Innovator, First Trust, and TrueMark offer monthly defined outcome ETFs (an product whose outcome period starts in April, in May, and so on), while AllianzIM and Pacer issue quarterly products.

Todd Rosenbluth, director of ETF Research at CFRA, says that while the funds are called defined outcome, investors should know they may not be able to exactly pinpoint their ultimate upside or downside, rather, they’ll “know the guardrails with the risk-managed income ETF.”

Buffered ETFs Pass the Real-World Test

Phon Vilayoune, founder and CEO of Veta Investment Partners, says the coronavirus’s market impact reminded investors that the stock market is inherently volatile.

“Everyone is looking pretty good when there’s a bull market. But when the market sells off, it sells off really fast. So the buffered ETF gives you time to think (about your next move),” Vilayoune says.

He uses AllianzIM’s products, including the firm’s large cap 10% and 20% buffered outcome ETFs (examples include the AllianzIM U.S. Large Cap Buffer10 Oct ETF (AZAO) or the AllianzIM U.S. Large Cap Buffer20 Oct ETF (AZBO)). With stock indexes at all-time highs, he is currently using the 20% buffer, but if markets weren’t so strong, he would use the 10% buffer. Depending on the client, these ETFs might replace anywhere from 10% to 30% of the equity allocation in a traditional 60/40 portfolio.

A number of other advisors are using these products in model portfolios or as core holdings, including Tim Hooker, the co-founder of Dynamic Wealth Solutions. This firm uses First Trust’s defined outcome ETFs, including a CBOE Vest Growth-100 Buffer series ETF that uses FLEX options on the Invesco QQQ Trust (QQQ). Defined outcome funds can compromise up to about 20% of his clients’ core portfolios, acting as a hedge to offset the portfolio’s exposure to QQQ and giving his tech-focused clientele some downside protection.

Meanwhile, Austin Smith, chief investment officer at Schulz Wealth, uses buffers for all of his clients, even the younger ones, as he doesn’t feel comfortable exposing them to all equity. He prefers Innovator’s Buffer funds, which offer a 9% downside protection combined with an upside cap of 14% (one example is the Innovator S&P 500 Buffer ETF (BMAY) That, he says, allows them to still participate in rallies, and retains the ability to trade out of the ETF if his clients are about to hit the cap.

Buffered products are good for clients who are otherwise too skittish to be in stocks, says Nick Olesen, director of private wealth at Kathmere Capital Management, who also uses them in model portfolios. He says clients are more likely to be in the market if they feel some of their money will be protected.

As a Bond Alternative?

Several advisors are even using defined outcome ETFs to replace bonds, which typically have served as a portfolio ballast to equities. It may be hard to argue in favor of bonds with interest rates so low.

Victoria Bogner, CEO at McDaniel Knutson Financial Partners, who has used the Innovator series since their launch, says her firm has replaced much of its bond allocation with defined outcome ETFs, saying the upside and downside is better than bonds.

“That’s a no brainer to use in place of bonds,” she says.

For Smith’s mature, higher-balance clients, who may be bond-averse due to the low yields, he swaps out some bond exposure with a combination of Innovator’s Power Buffer funds, with a 15% downside protection, and Ultra Buffer funds, with a 30% downside buffer. In these portfolios, he may end up with one-third in traditional equity, one-third in buffered ETFs, and one-third in bonds.

“There’s two-thirds of your money that has a potential to grow. But there’s also two-thirds of your money that has downside protection on it, with the bonds and buffers offering downside protection,” he says.

Yet Mark Andros, associate portfolio manager at Regency Wealth Management, cautions against thinking of buffered ETFs as a 1-to-1 bond replacement.

“It might exhibit similar risk or characteristics (to something bond-like), but the underlying positions themselves are not bonds. I would caution advisors who would think that this is a bond portfolio. It’s a low beta S&P 500. That’s probably how I would better describe it,” he says.

What to Keep in Mind

Buffered ETFs are more complicated products than many advisors are used to, and they come with some significant caveats. For starters, costs are often higher than for simpler downside protection strategies: Expense ratios range from 0.74% for AllianzIM’s products, up to First Trust’s products at 0.85%.

Additionally, although these funds are designed to be buy and hold positions, they aren’t “set it and forget it” funds. Bogner says she’s built a spreadsheet to do a daily Black-Scholes calculation on the options to understand the underlying options’ daily return probability, because it’s not possible to compare the different ETFs at face value.

There’s also a lag in returns between how the benchmark performs and how these ETFs perform, due to how options work; so advisors shouldn’t expect one-to-one returns Olesen says.

“If the market is up 9%, these will be up maybe 3-4% because of that lag,” he says.

In addition, trading buffered ETFs can be tricky because of their lower liquidity. Sometimes bid/ask spreads aren’t tight, meaning advisors who want to use them tactically—such as selling an ETF that’s nearing its cap—must be careful.

“We always do orders through the block desk and make sure we get quotes, because [without doing so,]the bid-ask spread can be a little higher,” Smith says.

If he wants to sell an ETF to find one with a higher cap, he’ll wait until a new series is launched to take advantage of higher liquidity, he says, which makes timing important. Advisors need to be prepared to be more actively involved using these funds.

“These ETFs are a much more hands-on piece than any other any other part of our portfolio,” he adds.

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