Investing in stocks can seem like walking a tightrope without a safety net. A new breed of exchange-traded funds aims to change that. These funds, called buffered or defined-outcome ETFs, absorb a portion of stock market losses in exchange for capping some of the gains.
"This is a solution for investors who want to protect on the downside," says Ryan Issakainen, head of ETF products at First Trust Advisers.
Other investments, such as low-volatility stock funds, also promise to cushion against market gyrations. But buffered ETFs, by investing in one-year options linked to a broad benchmark, differ in that they set exactly how much in losses – 9%, 10%, 15%, 20% or 30% before fees, depending on the fund – shareholders are protected from over a 12-month period.
How much you give up in returns depends in part on the amount of protection the fund offers. The greater the cushion, the smaller the potential gain. "These strategies provide risk mitigation first," says Johan Grahn, head of ETF products at Allianz Investment Management. "They are not built to hit home runs."
The first buffered ETFs launched in August 2018. Since then, another 70-odd defined-outcome funds have opened. Innovator and First Trust are the largest providers; AllianzIM and TrueShares entered the market in 2020. Because the funds rely on one-year options, the names of buffered ETFs include a month of the year, signaling the start of the 12-month period.
How Buffered ETFs Work
Most buffered ETFs are linked to the S&P 500 Index. Innovator S&P 500 Buffer ETF February (BFEB (opens in new tab)), for example, tracks the SPDR S&P 500 ETF Trust (SPY (opens in new tab)). Investors who bought shares in BFEB at the start of February 2021 have a 9% buffer against losses.
That means SPY can drop by up to 9% over the 12-month period from February 1, 2021, to January 31, 2022, and shareholders will lose nothing. But losses beyond the 9% buffer are not shielded. So if SPY declines, say, 15% over the 12-month period, BFEB shareholders (who bought in early February) will suffer a 6% loss.
On the flip side, BFEB’s potential return tops out at 18%, before fees, over the 12-month period. Any gains beyond that are forfeited. At the end of the one-year period, the fund resets by buying new options, which will define the parameters over the next 12-month period.
Buffered ETFs, all actively managed, carry an expense ratio of roughly 0.80%; the most common buffer is about 10%. Innovator and First Trust have funds that offer bigger cushions that work a little differently. You absorb the first 5% drop, and the fund absorbs up to the next 30 percentage points in losses. Allianz offers a series of funds with a 20% cushion.
TrueShares' funds differ on the upside. Instead of accepting a percentage-point limit on potential returns, investors in TrueShares defined-outcome ETFs can expect to reap roughly 83% of the S&P 500's price returns over any given 12-month period. That's a plus, because gains could be less curtailed relative to other buffered ETFs as long as the S&P 500 keeps rising.
Buy shares in a defined-outcome ETF within a week of the start of its 12-month stretch to take advantage of the fund's full downside buffer. In late May or early June, for example, buy a June-dated ETF. And plan to hold the ETF for at least the full year. For investors who don't buy at the start of the period, note that the buffer and cap shift a bit depending on the fund’s net asset value each day.
Nellie joined Kiplinger in August 2011 after a seven-year stint in Hong Kong. There, she worked for the Wall Street Journal Asia, where as lifestyle editor, she launched and edited Scene Asia, an online guide to food, wine, entertainment and the arts in Asia. Prior to that, she was an editor at Weekend Journal, the Friday lifestyle section of the Wall Street Journal Asia. Kiplinger isn't Nellie's first foray into personal finance: She has also worked at SmartMoney (rising from fact-checker to senior writer), and she was a senior editor at Money.
Gaining More Certainty in Your Retirement Income Plan
Relying on market performance to close the gap in your retirement income could let you down, but a CD ladder and fixed annuities could provide some certainty.
By Cole Czajkoski, Investment Adviser Representative • Published
Considering a 1031 Exchange? The Rules You Need to Know
Taxes are an inevitable part of investing in real estate. You can, however, defer or avoid paying capital gains taxes by following some simple rules of a 1031 exchange. Yes, you read that correctly!
By Daniel Goodwin • Published
The 5 Best Actively Managed Fidelity Funds to Buy Now
mutual funds In a stock picker's market, it's sometimes best to leave the driving to the pros. These Fidelity funds provide investors solid active management at low costs.
By Kent Thune • Published
The 12 Best Bear Market ETFs to Buy Now
ETFs Investors who are fearful about the more uncertainty in the new year can find plenty of protection among these bear market ETFs.
By Kyle Woodley • Published
Don't Give Up on the Eurozone
mutual funds As Europe’s economy (and stock markets) wobble, Janus Henderson European Focus Fund (HFETX) keeps its footing with a focus on large Europe-based multinationals.
By Rivan V. Stinson • Published
10 Bond Funds to Buy Now
Investing for Income Bond funds have seen sizable losses so far this year, but yields are now rising to attractive levels for income-starved investors.
By Adam Shell • Published
Vanguard Global ESG Select Stock Profits from ESG Leaders
mutual funds Vanguard Global ESG Select Stock (VEIGX) favors firms with high standards for their businesses.
By Rivan V. Stinson • Published
Kip ETF 20: What's In, What's Out and Why
Kip ETF 20 The broad market has taken a major hit so far in 2022, sparking some tactical changes to Kiplinger's lineup of the best low-cost ETFs.
By Nellie S. Huang • Published
ETFs Are Now Mainstream. Here's Why They're So Appealing.
Investing for Income ETFs offer investors broad diversification to their portfolios and at low costs to boot.
By Nellie S. Huang • Published
Do You Have Gun Stocks in Your Funds?
ESG Investors looking to make changes amid gun violence can easily divest from gun stocks ... though it's trickier if they own them through funds.
By Ellen Kennedy • Published