The primary driver of returns for buffered outcome ETFs will simply be the returns of the underlying asset, in most cases the S&P 500. What matters, however, is the direction and the scale and of the returns.
Assuming that the buffered ETF is utilizing a simple put-spread collar trade, the following could be expected:
To the downside, once the market falls past the first inflection point the buffered ETF should be sheltered from further losses, up until the point of the second inflection point. After the second inflection point the buffered ETF’s return will be fully exposed to further losses in the market. Please see the post on put-spread collars for further explanation.
The risks to most buffered ETFs lie in the extremes. If the market is up a lot, the buffered ETF will not enjoy gains beyond a certain point. If markets sell off too much, the buffered ETF is exposed to open-ended losses. The former is an opportunity cost and the latter is a very real risk to capital.
In addition, it should be noted that the specific returns advertised by these products are almost never realized given that those returns rely on investment on a specific date and holding the investment through expiration (e.g., one year). Investors who join after the launch or leave the series before the end of the period may receive far different returns. The structured returns are only there for investors who invest on a particular date and then stay the entire time.
Buffered ETFs may be used in a number of ways, including as an equity diversifier or as a means to move cash ‘off the sidelines’ while attempting to mitigate risk. Given these ETFs have a defined outcome period, or expiration date, investors will need to consider what to do after the outcome period ends and the potential market conditions at that time. Again, the risk mitigation zones can be structured, but the corresponding upside cap may be different over time, as mentioned above.
As mentioned previously, a vast number of variations of buffered products have been released over the last few years. This is both a good thing and a bad thing. On a positive note, there are variants of the buffered ETFs to fit just about any risk profile, from very conservative to very aggressive. If an investor has a specific buffer in mind, odds are that someone has an ETF to match.
On the downside, this means the investor must really do their due diligence and understand the trade-offs between upside potential and downside risks before investing in a particular strategy. Also, as all the “basic” variations of buffered outcome strategies have been released, many ETF companies are developing the next generation of buffered ETFs that might be more exotic than a basic put-spread collar. These variations might have risks that differ significantly from a basic put-spread collar and might impact an investor portfolio in unexpected ways.
Marc Odo, CFA®, FRM®, CAIA®, CIPM®, CFP®, Director of Investment Solutions, is responsible for helping clients and prospects gain a detailed understanding of Swan’s Defined Risk Strategy, including how it fits into an overall investment strategy. His responsibilities also include producing most of Swan’s thought leadership content. Formerly Marc was the Director of Research for 11 years at Zephyr Associates.
Swan Global Investments is an SEC registered Investment Advisor that specializes in managing money using the proprietary Defined Risk Strategy (DRS). Please note that registration of the Advisor does not imply a certain level of skill or training. All investments involve the risk of potential investment losses as well as the potential for investment gains. Prior performance is no guarantee of future results and there can be no assurance that future performance will be comparable to past performance. This communication is informational only and is not a solicitation or investment advice. Further information may be obtained by contacting the company directly at970-382-8901 or www.swanglobalinvestments.com. 279-SGI-102121