Why “Buffer” ETFs Aren’t What They Are Cracked Up to Be

When market volatility strikes, there are a few things you can usually expect to see. Fearful headlines. An overarching scary story. And articles highlighting investment vehicles purporting to help cushion the blow. This time, we are seeing the latter surrounding so-called “buffer” ETFs, which claim to provide investors upside without (much) downside. As Fisher Investments founder and Executive Chairman Ken Fisher says, though, “investment strategies promising both growth and capital preservation are phony baloney.”

Buffer or defined outcome ETFs use option strategies with the aim of limiting downside to varying degrees. So, for example, a 9% buffer ETF we reviewed based on the S&P 500 offers to cut paper losses by that amount. E.g., if the S&P 500 dropped -9%, an investor would lose nothing (not including fees). Past the threshold, say if the S&P 500 fell -15%, then the buffer ETF would lose -6%.

But there is no free lunch, and you must always pay the piper: Buffer ETFs also cap upside, which may differ from the amount of downside protection. The same 9% buffer ETF has a 15.85% cap, so if the S&P 500 rose 10%, an investor would participate fully. If the S&P 500 appreciated 20%, though, the investor would still gain only 15.85%. The reason they cap upside: Buying downside protection is often expensive, so to help offset this cost, the fund sells a call option—in this case, the right to buy the S&P 500 at a price 15.85% higher than at the contract’s start date.

Note the practical effect this has: an asymmetrical risk-return structure that doesn’t favor investors. While buffer ETFs offer downside protection, it is limited. In our example above, after the initial -9% “buffer,” an investor would still participate in all losses exceeding it. Whereas buffer ETFs’ losses are potentially unlimited, the hard cap on gains means an investor would miss out on all upside beyond it. There is a tradeoff: A bigger downside buffer generally goes with a lower cap on gains and vice versa—a smaller downside buffer usually allows a higher cap. But either way, buffer ETFs’ unlimited loss potential outweighs their potential gain. Then consider the S&P 500’s bull market returns average 23.0% annualized.^[i] And that the index has risen in 74% of all calendar years since 1926.^[ii] We think this makes their lopsided risk-return potential much less enticing.

Also, most buffer ETFs employ options contracts for 12-month periods, resetting annually. This means the buffers and caps they advertise apply only for investors who buy on the rebalance date and hold until expiration. Buying and selling within this “outcome period”—between contract expiry and reset dates—could mean less (or more) downside protection and more (or less) upside exposure. So, for the current “March series” of the 9% buffer ETF we reviewed that began at the month’s start, with the S&P 500 down a few percent month to date, the remaining buffer is less than 7%.^[iii] Meanwhile, its 15.85% cap it had on March 1 expanded to over 17%. This is the buffer and cap an investor would get if they bought now, which won’t reset until next March.

A buffer ETF is basically a pre-packaged options strategy. That isn’t a free lunch, nor is it capital preservation and growth, which are two conflicting goals that are impossible to target simultaneously. It comes with all the inherent drawbacks of an options-based approach. Buffer ETFs essentially use a covered call-writing strategy which, as Ken Fisher shows in his best-selling books The Only Three Questions that Count and Debunkery, equates to using complex securities to reduce market exposure. Generally speaking, people own stocks because their goals require market-like returns in the long run. The options strategy used here, which caps upside but not downside, inherently reduces long-term return potential. Not only does it not help much when you really need it—in big down markets—it is a losing strategy in markets that generally trend upward and therefore goes completely counter to the principle of stocks’ high long-term returns being compensation for the risk of short-term declines.

The ETF packaging doesn’t make the security itself any less complex, either. In our view, investors still need to know their options exposures, how they work and where they stand on any given day. Note, too, the options they use are usually based only on price returns, so investors forgo dividends. Moreover, besides their complexity, the added bells and whistles come with high fees—buffer ETFs can have expense ratios of 0.7% or more, versus many plain vanilla index funds at less than 0.1%.^[iv] Lastly, although there is no lock in—you can get out any time—you won’t get the benefit of the buffer if you sold while the market was down before the outcome period ends, effectively committing you to a one-year holding period.

If you find yourself considering buffer ETFs, think carefully and honestly about why. If it is because of market volatility and your emotional reaction to it, that is a common and understandable urge, but acting on it in the heat of the moment likely proves counterproductive. Take note of your feelings and the temptations they create, then reflect with a cooler head once you have some distance on this spurt and consider whether you would benefit from an approach that swings less than the market—with full consideration that volatility cuts both ways. If it is because your actual financial goals and needs have changed, with more emphasis on cash flow, we think there are better options than, well, options—the outcomes of which, like stocks, depend on sentiment swings that are impossible to time. Shifting your asset allocation more toward bonds is a much more cost-effective way to reduce expected short-term volatility.

Products like buffer ETFs tend to gain popularity after bear markets and during volatile patches like the present. They play on people’s emotions—but there is a high price for acting on natural tendencies to avoid losses. That makes it doubly important to do your due diligence and discover such investment products’ costs, pros and cons.