Are buffer ETFs suitable for your clients?

Many people have noted that a higher interest rate environment and geopolitical uncertainty is causing ongoing volatility in the markets. As a result, investors are seeking risk management strategies that can assist them in navigating market unpredictability.

Richard Ho, Director, ETF Distribution, BMO Global Asset Management, discusses how buffer exchange-traded funds (ETFs)—unique investment vehicles—offer risk management, and can be a prudent part of an investor’s overall investment portfolio.

Q: What do investors need to be aware of when considering buffer ETFs?

Richard Ho: There are a few key components that investors need to pay attention to. First is the reference asset, which is the underlying asset the ETF return is based on. Let’s say the buffer ETF is in reference to the S&P 500 hedged in Canadian dollars. This means the buffer will provide S&P 500 currency hedged price returns, up to cap, and will also provide downside protection. The latter is called the buffer protection, which is the predefined protection the investor will get over the outcome period of the buffer ETF.  The BMO US Equity Buffer Hedged to CAD ETFs provide exposure to the S&P 500 hedged to Canadian dollars (Tickers: ZOCT, ZJAN, and more recently, ZAPR).   

The other element is the upside cap, which tells the investor what their potential maximum upside is.

Lastly, there’s the outcome period, which is typically one year. For instance, if the investor buys a buffer ETF on Jan. 2, it will have a lifespan of approximately 365 days. Of course, a buffer ETF is perpetual, meaning the investor can hold that same buffer ETF even after that one-year period. After that one-year period, the investor will still get that same downside protection (in BMO’s case, that’s 15%) for the next period, but that upside cap will simply reset at new levels based on market conditions.

Q: How do buffer ETFs differ from traditional ETFs?

RH: A buffer ETF is designed to help investors achieve the price return, up to a cap, on the reference asset with downside protection, which is obtained by using different option strategies. Whereas, with a traditional ETF, investors simply have the exposure return without any downside protection; there aren’t any option strategies embedded inside traditional index ETFs.

Q: What benefits do buffers offer investors?

RH: Buffer ETFs allow investors to stay invested during periods of volatility without experiencing the full market drawdown because of the buffer zone, or downside protection. These products are especially attractive to investors who are more risk averse or nearing retirement, as they may not want to take on additional risk in their portfolios. So, a buffer ETF could be a consideration to help manage market uncertainty and risk as part of their overall investment portfolio.

Q: How do buffers integrate risk management while allowing for upside participation?

RH: Risk management is offered by integrating put options, which are essentially an insurance policy for your investment. The put spread hedge will absorb a defined amount of loss, giving investors comfort in dialing down equity risk. To finance that insurance policy, we sell call options. These two strategies together allow us to package a cost-effective (the management fee is 0.65%), transparent way for investors to stay invested in equity markets with predefined protection. So if the market is going to be more volatile, they will still be protected or shielded against the first 15% of market losses.

Q: What types of investors are buffers most suited for?

RH: Investors who prioritize the benefits of having a risk management solution embedded inside an ETF could consider using buffer ETFs. Most investors tend to fall into a few categories. First, there’s the investor who is very risk averse or conservative; they are known to prioritize capital preservation. They want to minimize risk, and they’re not doing anything to strive for a home run in their investments. What they want is long-term growth, and stability. That’s what buffer ETFs can provide.

Second, many investors right now are sitting on the sidelines, in cash. They don’t have much appetite for risk. Maybe getting a 5% yield on their fixed income or GICs is sufficient. These investors sitting in cash could consider buffer ETFs because they can return to equity markets with less downside risk.

In terms of demographics, retirees who depend on their investments for retirement could also reap the benefits from buffer ETFs. That’s because they aim to safeguard their portfolios against market downturns, ensuring the protection of their savings for retirement. Again, a buffer ETF is a good solution for that. Overall, buffers are beneficial for investors who prioritize capital preservation and want stability, which is, essentially, everyone.

DISCLAIMER

An investor that purchases Units of a Structured Outcome ETF other than at starting on the first day of a Target Outcome Period and/or sells Units of a Structured Outcome ETF prior to the end of a Target Outcome Period may experience results that are very different from the target outcomes sought by the Structured Outcome ETF for that Target Outcome Period. Both the cap and, where applicable, the buffer are fixed levels that are calculated in relation to the market price of the applicable Reference ETF and a Structured Outcome ETF’s NAV (as Structured herein) at the start of each Target Outcome Period. As the market price of the applicable Reference ETF and the Structured Outcome ETF’s NAV will change over the Target Outcome Period, an investor acquiring Units of a Structured Outcome ETF after the start of a Target Outcome Period will likely have a different return potential than an investor who purchased Units of a Structured Outcome ETF at the start of the Target Outcome Period. This is because while the cap and, as applicable, the buffer for the Target Outcome Period are fixed levels that remain constant throughout the Target Outcome Period, an investor purchasing Units of a Structured Outcome ETF at market value during the Target Outcome Period likely purchase Units of a Structured Outcome ETF at a market price that is different from the Structured Outcome ETF’s NAV at the start of the Target Outcome Period (i.e., the NAV that the cap and, as applicable, the buffer reference). In addition, the market price of the applicable Reference ETF is likely to be different from the price of that Reference ETF at the start of the Target Outcome Period. To achieve the intended target outcomes sought by a Structured Outcome ETF for a Target Outcome Period, an investor must hold Units of the Structured Outcome ETF for that entire Target Outcome Period.

Commissions, management fees and expenses all may be associated with investments in exchange traded funds. Please read the ETF Facts or prospectus of the BMO ETFs before investing. Exchange traded funds are not guaranteed, their values change frequently, and past performance may not be repeated.

For a summary of the risks of an investment in the BMO ETFs, please see the specific risks set out in the BMO ETF’s prospectus. BMO ETFs trade like stocks, fluctuate in market value and may trade at a discount to their net asset value, which may increase the risk of loss. Distributions are not guaranteed and are subject to change and/or elimination.

BMO ETFs are managed by BMO Asset Management Inc., which is an investment fund manager and a portfolio manager, and a separate legal entity from Bank of Montreal.

This material is for information purposes. The information contained herein is not, and should not be construed as, investment, tax or legal advice to any party. Particular investments and/or trading strategies should be evaluated relative to the individual’s investment objectives and professional advice should be obtained with respect to any circumstance. ®/™Registered trademarks/trademark of Bank of Montreal, used under license.