Buffer Funds | Defined-Outcome ETFs

Buffer funds – aka buffer ETFs or defined-outcome ETFs – are designed to address a fundamental psychological barrier many traders and investors face: the fear of losses outweighing the desire for gains. 

These funds offer a unique value proposition – they provide exposure to market upside while incorporating downside protection up to a predetermined level.

Key Takeaways – Buffer Funds

• The Basics
  • Create synthetic index
  • Cap upside by selling calls, limit downside by buying puts
  • Modified collar structure
• Downside Protection
  • Buffer ETFs offer protection from market losses up to a set percentage, reducing downside risk for investors.
  • Sometimes full protection depending on product design.
• Capped Upside
  • These funds limit potential gains – i.e., sacrificing growth beyond a predetermined level in exchange for protection.
• Options-Based Strategy
  • Buffer ETFs use options contracts to create synthetic exposure, enabling the fund’s protective and growth features.
• One-Year Cycle
  • Caps and buffers are reset annually.
  • Make timing important for buyers who want full protection.
• Cost and Fees
  • The options strategy involves rolling costs and performance drag, which can reduce returns compared to direct index investments.

Growth in Buffer Funds

Since their introduction in 2018, buffer ETFs have experienced remarkable growth.

Over 160 such funds have been launched, collectively amassing more than $27 billion in assets.

The Mechanics Behind Buffer ETFs

Origins in Structured Products

Buffer funds are essentially structured products wrapped in an ETF format.

Traditional structured products are packages of derivative contracts linked to various financial metrics or assets, such as:

• Equity indexes
• Credit spreads
• Interest rates
• Commodity prices

The Three-Layer Strategy

Buffer ETFs typically use a three-pronged approach:

• Synthetic Index Exposure – The fund uses options to replicate the performance of an underlying index
• Downside Buffer Creation – A put option is purchased to provide the right to sell at a specific price, creating the buffer
• Finance Layer – The fund sells both call and put options to offset the cost of the protective put

The Options at Play

These funds primarily utilize flexible-exchange (FLEX) options, which offer:

• Customizable strike prices and expiration dates
• Clearing through the US Options Clearing Corporation (OCC)
• Lower counterparty risk compared to private swaps
• Regulatory oversight by both the SEC and CFTC

Product Design & Diagram of Buffer Fund Structure

A synthetic index can be created by buying a call and selling a put, roughly at the same price.

The returns can be capped by selling a call option.

The downside can be capped by buying a put option.

The costs of the put and any net loss on the synthetic index creation (calls are generally more expensive than puts when interest rates are above zero, all else equal) by selling an OTM put option (in addition to the sold call option), which some buffer funds do.

All options in buffer funds are typically one-year expiries.

Example #1

Let’s say the goals of the client are as follows:

• Long exposure to an index
• Downside limited to 10% with half-losses from that point forward (e.g., a 30% fall in the index would produce 20% losses)

Here’s how the product would be designed:

Design the synthetic index

• Long 2 100 Calls
• Short 2 100 Puts

Define the upside to 10%

• Short 2 110 Calls

Define the downside to 10% and cap losses to 50% of a further falls

• Long 1 90 Put

Diagram

Here’s our option payoff diagram:

Example #2

Let’s say the goals of the client are as follows:

• Long exposure to an index
• Downside limited to 10%, up to 20% losses
• Accept further losses after a 20% fall to recoup costs of sold options

Here’s how the product would be designed:

Design the synthetic index

• Long 1 100 Call
• Short 1 100 Put

Define the upside to 10%

• Short 1 110 Call

Define the downside to 10%

• Long 1 90 Put

Accept losses after a 20% fall

• Short 1 80 Put

Diagram

Here’s our option payoff diagram:

Key Characteristics and Limitations

The Outcome Period

Most buffer ETFs operate on a one-year cycle, known as the outcome period.

This timing is important because:

• Stated caps and buffers only apply to those who buy on the rebalance date
• Mid-period buyers receive different protection levels based on index performance since the last rebalance
• Fund sponsors typically provide real-time updates on remaining buffers and caps

Critical Trade-offs

Upside Limitations

• Capped Returns – Investors sacrifice potential gains beyond a certain threshold.
• Dividend Exclusion – Exposure is limited to price returns only. Dividends aren’t captured, though theoretically you could design such products by buying the underlying index rather than constructing a synthetic index with options.
• Rolling Costs – The regular replacement of options contracts can create performance drag

Downside Considerations

• Partial Protection – The buffer only covers losses up to a certain percentage
• Resumed Losses – Once the buffer is exceeded, the fund begins participating in market declines
• Asymmetric Risk Profile – These funds often have greater potential for loss than gain

Cost Considerations

While buffer ETFs offer unique benefits, investors should be aware of:

• Potentially opaque fee structures within the options strategy
• The impact of volatility on option pricing and strategy terms
• Impact of interest rates on option pricing
  • All else equal, higher rates increase the cost of calls relative to puts
  • Conversely, lower rates increase the cost of puts relative to calls
• Performance lag compared to direct index investment due to options costs

Advantages Over Traditional Structured Products

Enhanced Liquidity

The ETF wrapper provides:

• Daily trading capability
• Better price discovery
• Easier exit options for investors

Improved Transparency

Compared to traditional structured products, buffer ETFs offer:

• Clearer fee structures
• Daily disclosure of holdings

Example Buffer Funds

Here are some examples of existing buffer ETFs, focusing on the major providers and some key features:

Innovator ETFs

• Innovator US Equity Buffer ETFs – This suite of ETFs offers a defined outcome strategy with a buffer level (e.g., 9%, 15%) against a specified percentage of S&P 500 index losses over a defined outcome period (typically one year). They have varying upside caps depending on the buffer level and market conditions.  
• Innovator NASDAQ-100 Managed Floor ETFs – These ETFs track the NASDAQ-100 Index, with a managed floor designed to limit potential losses.  
• Innovator US Equity Power Buffer ETFs – These ETFs provide a buffer against S&P 500 Index losses and have upside participation that can be greater than traditional buffer ETFs, with higher upside caps in favorable markets (i.e., bull markets for stocks).
• Innovator Defined Outcome ETF Model Portfolios – These are model portfolios that include a mix of Innovator’s Defined Outcome ETFs. They look to provide advisors with a diversified approach to defined outcome investing.  

First Trust

• FT Cboe Vest US Equity Buffer ETF (BUFB) – This ETF series offers a 10% buffer against losses in the SPDR S&P 500 ETF Trust (SPY) over a defined outcome period. There are 12 ETFs in the series. Each has a different outcome period corresponding to a calendar month.

iShares

• iShares Large Cap Moderate Buffer ETFs – These ETFs seek to track the return of the Morningstar Large Cap Index, up to a cap, while buffering against the first 10% of losses.
• iShares Large Cap Deep Buffer ETFs – These ETFs provide a deeper buffer (typically 20-25%) against losses in the Morningstar Large Cap Index, but with a lower upside cap compared to moderate buffer ETFs.

JPMorgan

• JPMorgan Hedged Equity ETFs – These ETFs offer a more flexible approach to hedging. Allows investors to choose the level of downside protection and upside potential.

Key Features to Consider

• Underlying Index – The index that the ETF tracks (e.g., S&P 500, Nasdaq-100).  
• Buffer Level – The percentage of losses that the ETF aims to protect against.
• Upside Cap – The maximum potential return of the ETF over the outcome period.
• Outcome Period – The defined period over which the buffer and cap apply (typically one year).
• Expense Ratio – The annual fee charged by the ETF.

Practical Considerations for Investors

Suitability Assessment

Buffer ETFs may be best for:

• Risk-averse investors still looking for stock market exposure
• Portfolios needing targeted downside protection
• Investors willing to sacrifice some upside potential

Integration Strategies

Consider:

• Using buffer ETFs as a complement to traditional equity exposure
• Using them as part of a broader risk management strategy

Buffer ETFs: Suitable Investor Profiles

Buffer ETFs are suitable for a range of investor profiles beyond the broadly defined “risk-averse investors.”

A more nuanced assessment can help individuals decide if these funds align with their financial goals and risk tolerance:

Pre-Retirement Investors

Buffer ETFs can be a good fit for those nearing retirement who want equity exposure but are concerned about market downturns affecting their savings.

The downside protection helps shield retirement assets while still participating in market gains, albeit with capped upside.

Conservative Growth Seekers

Investors trying for modest growth with reduced downside exposure might find buffer ETFs attractive.

These funds allow participation in market rallies while limiting losses during declines, which can be appealing for those with moderate risk tolerance.

Income-Focused Investors Seeking Protection

Individuals relying on investment income may use buffer ETFs to supplement their portfolios while reducing the potential impact of significant market drops.

Wealth Preservation Investors

High-net-worth individuals focused on preserving wealth, rather than maximizing returns, may incorporate buffer ETFs to balance the risk-reward ratio in their equity allocation.

Behaviorally Challenged Investors

Some investors struggle with emotional responses to market volatility, leading to poor decision-making.

Buffer ETFs help manage downside risk, which can reduce panic-driven reactions and promote disciplined investing.

Portfolio Diversification Users

Buffer ETFs can be part of a broader strategy for diversifying risk.

Investors seeking alternative methods of portfolio protection alongside bonds or other defensive assets might find them useful as a complement.

Are Buffer Funds Suitable for Traders?

Buffer funds may not be ideal for most traders due to their one-year outcome period and capped upside, which limit short-term gains and flexibility.

They could nonetheless appeal to traders seeking structured downside protection during volatile market phases.