What is a buffered ETF?
What are defined-outcome ETFs?
What is a Target Outcome ETF?
All the same thing – you’ve come to right place.
A Defined Outcome ETF, also known as a Buffered ETF or Target Outcome ETF, is a type of exchange-traded fund (ETF), or financial product, that provides some protection for your investments. They're designed to protect your money from some losses in the stock market while still allowing you to benefit from some potential gains. Most do not protect against tail risk, so they do not protect against significant losses past the downside buffer amount. They are considered an alternatives strategy or an options strategy.
Think of it like this: You have some money invested in the stock market, and you want to protect it from big drops. Buffered ETFs use a purely derivatives (options) strategy to accomplish this. The trade off is that the upside is usually capped as well. These ETFs normally trade daily like stocks and are liquid.
Here's how it works:
The upside: The buffered ETF invests in synthetic exposure to the index through call options and short put options. This allows them to gain exposure to the underlying index, which is tracked through options on an ETF. This is the way the investor can potentially benefit from an increase in stock market performance.
The downside: This is where the protective part comes in. The ETF uses options to create a downside buffer. These options are like insurance policies. If the stock market goes down a bit, the options can help absorb some of the losses, acting as a financial cushion. But, if the market goes down a lot, beyond the stated downside buffer, then the investor is exposed to more losses on the downside. See the hypothetical example below.
So, in simple terms, buffered ETFs are a way to have a bit of protection for your investments. They won't make you super rich during a bull market, but they can help limit your losses when the market gets rough.
Let’s look at a hypothetical example (and see below for further details).
It is October 1st and the S&P 500 has recently dropped 10%. There is an October issued buffered ETF, linked to the S&P 500, that resets each year. So, if an investor was afraid the market was going to drop further, they might want to consider this October issue. It has a 15% downside buffer, meaning they would lose nothing (except the expense ratio of the ETF) unless the S&P 500 declined over 15% by the next September 30th. If the S&P 500 declined 16%, then the investor would lose 1%. If it declined 20%, then the investor would lose 5%. They would also “lose” the expense ratio of the ETF, which could be around 0.70-0.90%.
Furthermore, that is what would happen if held until the following September 30th for the full one-year period. Since they are liquid and trade like stocks, they can be sold intra-period. If that is done, then the stated outcomes would not be achieved. The investor needs to hold the buffered ETF for the entire period to partake in the outcome. The buffered ETF will still decline intra-period even if the index falls within the buffer level. For example, intra-period if the index is down 10%, the buffered ETF will also decline in value. The investor cannot sell intra-period for their full money back until the full year has passed.
Now, on the upside, perhaps this October issue had a 14% cap. For this hypothetical, that means that the investor would earn 1-to-1 on the S&P 500 increase up to 14% if they held the position until the reset date the next year. So, if the S&P 500 increased 5%, the investor would see a 5% increase as well (less the expense ratio). If it increased 14%, the investor would see a 14% increase as well (less the expense ratio). But, if the S&P 500 increased 15%, the investor would only see a 14% increase because 14% was the stated cap at the issue date (less expense ratio). If the S&P 500 went up 20%, then the investor would still see only a 14% increase (and again, less the expense ratio). Additionally, since the buffered ETF does not invest in the index directly, instead synthetically through options, the investor does not benefit from the dividend.
Here is more detail of how a Defined Outcome ETF typically works:
- Outcome Period: These ETFs are usually designed for a specific period, such as a few months or a year. During this period, investors hold the ETF shares.
- Buffer and Cap: The ETF will have a "buffer" that limits potential losses up to a certain point. For example, it might offer a buffer of 10% below the starting value of the underlying index. Beyond this buffer, investors will start to experience losses. There's also often a "cap" that limits the maximum gains an investor can achieve, usually set above the starting index value.
- Underlying Index: The ETF's performance is tied to an underlying index or asset class, like the S&P 500 or a specific market sector.
- Structured Options: The ETF uses options contracts and derivatives to create this defined outcome structure. These options are essentially financial tools that allow for risk management and the creation of predefined risk-reward profiles.
- Rolling Strategy: Some Defined Outcome ETFs may use a rolling strategy, which means they reset at the end of each outcome period. This allows investors to potentially benefit from different market conditions over time. Investors are automatically rolled into a new outcome period if they don’t sell, which could come with a new cap. This new cap could be lower than the previous period’s cap.
These ETFs are popular among investors who want to participate in the stock market but with some downside protection. They're often used for hedging or to try achieve specific financial goals with known risk parameters.
However, it's crucial to understand that the protections provided by Defined Outcome ETFs are not free. Investors will sacrifice some potential upside in exchange for downside protection. Also, these funds can be more complex than traditional ETFs, so it's essential to thoroughly research and understand their specific terms and strategies before investing.
It's important to note that the specific option strategy and parameters can vary from one buffered ETF to another, so it's essential to review the prospectus or information provided by the ETF issuer to understand the exact terms and conditions of any particular buffered ETF linked to the S&P 500.
This material is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product.
Investing in alternative investments may not be suitable for all investors and involves special risks, such as risk associated with leveraging the investment, utilizing complex financial derivatives, adverse market forces, regulatory and tax code changes, and illiquidity. There is no assurance that the investment objective will be attained. Past performance is no guarantee of future results. Talk to your financial advisor before making any investing decisions.