Why Buffer ETFs May Fall Short for Long-Term Investors

Some ETFs have “buff” in their names, but that doesn’t mean they’re strong performers.

Buffer funds have become the largest category within ETFs by number of products, and they are among the fastest growing by assets. By employing options, they offer protection from losses, but that doesn’t necessarily serve most long-term investors well, according to a recent report from Morningstar. 

“They definitely fit best with investors that have shorter time horizons,” said Zachary Evens, Morningstar manager research analyst and the report’s lead author. Such investors might be near retirement and concerned about “black swan” events like Covid-19 or the 2008 financial crisis, he noted. “For investors that might not be able to stomach such a decline in the equity markets but have a longer time horizon, it could make sense on the behavioral side of it.”

Results May Vary

Two factors can hold back buffer ETFs. Obviously, the caps on positive returns are a limiter. But the funds’ fees tend to be higher than those of otherwise comparable funds, albeit without the protection against losses, which can be a drag on net returns. The S&P 500 index rarely dropped more than 20% during any 12-month period since 1970, though it went up 20% or more roughly a third of the time, the report noted. Most buffer ETFs would have protected against losses during that timeframe, though the extreme declines would have exceeded most protection limits, and investors would have missed much of the stock market rebounds because of caps.

There is also a wide range of products out there:

• About 420 defined-outcome ETFs were on the market as of the end of last year, representing $78 billion, per Morningstar.
• Many offer protection on 15% of losses, though some go as far as 100% principal protection. They are also available for assets ranging from US equities to bitcoin.
• The two biggest issuers, First Trust and Innovator (which is being acquired by Goldman Sachs), have about $40 billion and $28 billion in defined-outcome ETF assets under management, respectively.

Apples and Oranges? Buffer ETFs have done well for advisors who want to offer risk mitigation and precision to clients, said Matt Kaufman, head of ETFs at Calamos. And they offer a much more liquid alternative to insurance products like registered index-linked annuities, a category that has also been growing for years, he noted. Many investors have been using buffer ETFs for retirement spending, while some institutions have turned to them instead of hedge funds, he said. 

“If you view them as a bond-replacement, a risk-management tool, you can make the case that a large part of your portfolio can be allocated to buffered ETFs,” he said. “There’s a large number of Americans, especially retirees, whose goal is to provide for themselves … Their goal is not to maximize the Sharpe ratio.”