It has been said by many in the investments industry over the years that there are fundamentally two types of investors: 1. Those that wish to eat well, and 2. Those that wish to sleep well. Now, as with any reductionist statement, this view of the world doesn’t quite match reality, because there are complexities with human preferences related to investing and risk that are beyond the scope of this statement. Yet, nonetheless, there is a ring of truth to it and many people could easily place themselves in one of the two camps. It is in the spirit of providing an investment for people whom “sleeping well” is a higher priority than “eating well” that the burgeoning buffered ETF industry is flourishing.

What are buffered ETFs?

Buffered ETFs are investment products designed to participate in some of the gains in broad stock market advances while simultaneously hedging against some of the losses that stock markets can at times experience. This is achieved by using options hedging strategies inside of the ETF’s. It works this way:

• The ETF gains exposure to a stock index by purchasing an option on some index instrument (the SPY ETF is the most common instrument used in buffered ETFs) which provides the ETF with approximately 100% exposure to the instrument.
• The ETF then sells an out of the money call option beyond some level of gain, say 10%. This means the ETF will participate in the gains of the underlying instrument up to the 10% level (or whatever level the ETF provider chooses to sell the call option at). All gains after the 10% will go to the holder of the call option the ETF sold.
• The ETF buys downside protection with the proceeds of the sale of the call option by subsequently purchasing a put option at some level, say down 5%. This means the ETF will gain from its put position after the underlying asset has declined to its target loss. Thus, in this example, the investor is protected from losses beyond the initial 5% loss.

These buffered ETFs generally are managed to a one-year target, at which point they reset and begin a “fresh” year with new upside and downside parameters. While buffered ETF providers encourage a buy and hold approach, at WealthPlan our experience over four years is that it is better to actively manage them to reflect the realities that manifest in markets over a year. Simply put, these instruments are not all the same and some of them you clearly want to own and some of them you don’t, depending on market conditions.

The first buffered ETF was introduced in 2019, and since that time, there has been a proliferation of these instruments. There are over two hundred buffered ETFs and over $45 billion has been committed to them so far. And new ones are coming to market at a very rapid pace. These instruments have been very appealing to a segment of the investing population and there is reason to believe this type of hedged ETF will continue to experience growth and innovation.

Who are buffered ETFs for?

Buffered ETFs are designed, built, and managed for people who fundamentally are more about sleeping well than eating well. Sure, these folks would like to see some growth in their portfolios. but not at the expense of introducing risks that prevent them from sleeping well at night. Some people simply do not want to face the prospect of seeing their portfolio decline 22% in one day as many did in October of 1987, or seeing a prolonged decline of over 50% as many did in 2008 and 2009. Some people are not wired to accept this kind of risk. And others are at a point in their life where they simply cannot afford to take a hit like that. We find that many people who are approaching or in retirement are particularly well suited for an allocation to a buffered ETF portfolio. Moreover, for people who find the stock market’s strong returns of late combined with the stock market’s lofty valuations make them nervous, a buffered ETF strategy can bring them comfort while they still participate in some of the gains. Buffered ETFs are built for people like this.

How have Buffered ETFs performed? 

Fortunately, we didn’t need to wait too long after their introduction to see how Buffered ETFs performed in a down market, which occurred in 2022. The S&P declined almost 25% in 2022 before recovering some in the fourth quarter and closing the year down about 19%. Comparatively, two popular laddered buffered ETFs BUFF and BUFR finished the year down 4.5% and 7.6%, respectively.  Here is what it looked like:

Subsequently, in 2023, the S&P index rallied, up over 26% while BUFF and BUFR were up only 16.5% and 19.5% respectively. It looked like this:

As you can see, these strategies do truncate the downside experience that comes with stock investment. But the cost of limiting downside is that a person gives up some of the upside. Ultimately, whether this type of investment is right for investors comes down to their individual preferences and circumstances. Importantly, WealthPlan has been managing our own portfolio strategy comprised of buffered ETFs since the summer of 2020. We do it a little differently from the laddered strategies we have featured in the charts above and have differentiated ourselves by the selections we have made. If you are the type of investor who values sleeping at night above eating well, these strategies might be for you. Our advisors would be happy to have this conversation with you. Feel free to email or call us.

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DISCLOSURES

SPY seeks to provide investment results that, before expenses, correspond generally to the price and yield performance of the S&P 500® Index. The Trust seeks to achieve its investment objective by holding a portfolio of the common stocks that are included in the index (the “Portfolio”), with the weight of each stock in the Portfolio substantially corresponding to the weight of such stock in the index.

BUFF seeks investment results that generally correspond (before fees and expenses) to the performance of the FTSE Laddered Power Buffer Strategy Price Return Index. The fund will invest at least 80% of its net assets (including investment borrowing) in the exchange-traded funds (“ETFs”) that comprise the index. The index is composed of the shares of twelve Innovator U.S. Equity Power Buffer ETFs. The fund, in accordance with the index, will be continuously invested in each of the underlying ETFs and will rebalance semi-annually by purchasing and selling the underlying ETFs to equally weight the underlying ETFs.

BUFR seeks to provide investors with capital appreciation. The fund seeks to achieve its investment objective by providing investors with U.S. large-cap equity market exposure while attempting to limit downside risk through a laddered portfolio of twelve FT Cboe Vest U.S. Equity Buffer ETFs. Under normal market conditions, it will invest substantially all of its assets in the Underlying ETFs, which seek to provide investors with returns that match the price return of the SPDR S&P 500 ETF Trust, up to a predetermined upside cap, while providing a buffer against the first 10% of SPY losses, over a defined one-year period. The fund is non-diversified.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which Investment(s) may be appropriate for you, consult your financial advisor prior to investing. Information is based on sources believed to be reliable, however, their accuracy or completeness cannot be guaranteed.

No investment strategy can assure success or completely protect against loss, given the volatility of all securities markets. Statements of forecast and trends are for informational purposes and are not guaranteed to occur in the future. All performance referenced is historical and is no guarantee of future results. Securities investing involves risk, including loss of principal. An investor cannot invest directly in an index.

The information in this communication applies solely to the intended audience and in no way amends, revokes, or otherwise alters the existing agreements and relationships between WPIM and its clients.  This communication is not a binding offer, expressed or implied.  WPIM undertakes no obligation to update or revise the information herein or in any referenced third-party resource due to new information, future events or circumstances, or otherwise.

WealthPlan Investment Management (“WPIM”) uses data compiled and/or prepared by third parties (“Third Party Data”) in the delivery of Licensed Research and Data. Third Party Data is not owned by WPIM and user may be required to obtain permission directly from third parties for further use of Third-Party Data and may be required to pay a fee depending on the use contemplated by the user.