What are buffer ETFs?

Buffer exchange-traded funds (ETFs), also known as structured outcome ETFs, allow investors to track the performance of an asset or index. These solutions are newer to the market and growing in popularity.

Richard Ho, Director, ETF Distribution, BMO Global Asset Management, details what buffer ETFs are, and how they can provide investors with downside protection on their equity holdings.

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Q: How do buffer ETFs work?

Richard Ho: There are a couple of key things to understand. Buffer ETFs are designed to provide investors equity exposure with a predetermined level of downside protection. To obtain that downside protection, the portfolio manager uses a put spread, which is an option strategy that allows the investment to shield itself from market losses during the outcome period. For instance, BMO’s buffer ETFs protect investors for the first 15% of losses of the reference asset. It’s important to know what the reference asset is because it will deliver the market performance return of that reference asset or index. BMO US Equity Buffer Hedged to CAD ETFs provide exposure to the S&P500 hedged to Canadian dollars (Tickers: ZOCT, ZJAN and more recently ZAPR).    

To finance that buffer protection, the fund manager implements a call option. So, whenever investors sell options in the market, they earn an option premium, which is collected and used to pay for the insurance policy, that put spread. In addition, the buffer ETF has an upside cap on what the investor can expect over the lifespan of the ETF, typically a one-year term.

Q: How do buffer ETFs allow an investor to reshape the return profile of their portfolio?

RH: Buffer ETFs can help reshape the return profile by leveraging the options market to make it more attractive to investors who are more risk averse and want to protect their portfolios from market downturns without stepping away from the market. Utilizing buffer ETFs can help mitigate the risk of unknown market downturns while still maintaining exposure to the market.

How much to allocate towards a buffer ETF depends on an investor’s individual risk tolerance and time horizon. For some investors, including buffer ETFs as part of the overall construction of their portfolio could be beneficial.

Q: What is the difference between a long-only strategy and a buffer?

RH: When you use a buy-and-hold strategy, you’re exposed to market risk with no risk management or downside risk protection. But, if the investor is using a buffer strategy, they have that protection in case the market pulls back. For example, if the market is down 10%, the long-only investor is going to be down that 10%. Whereas the buffer investor’s losses will be shielded by that buffer, with the buffer absorbing the first 15% of those market losses.

The other thing that’s very compelling is the market drawdown. Let’s say the market drops by 20%. For the long investor to come back and break even to the initial point of their portfolio, it’s going to require a 25% gain to break even. But for the investor using a buffer strategy, it’s going to take only 5% to break even.

Q: How do buffers protect against volatility?

RH: Options are a great risk management tool. During times of extreme volatility, the correlations between the equity and fixed income markets tend to converge. For instance, during the financial crisis or the COVID-19 pandemic, the correlations between these two asset classes were very high. But with options, it’s a different story because the terms of the options contract embedded inside the buffer have to be respected, no matter what. Investors using a buffer ETF can navigate through volatile markets and have that downside protection.

Q: Are there any risks in using buffers?

RH: Buffer ETFs are created to reduce risk by having an embedded risk management strategy inside the portfolio. Investors enjoying this risk reduction strategy via options are trading away some of the upside. If the market goes up beyond the upside cap, then the investment might incur what we call opportunity costs. Buffer ETFs resonate with investors who are looking for less volatility in their portfolio and are willing to trade a little upside for that downside protection.

Q: What type of markets are best suited for buffer ETFs?

RH: Buffer ETFs are good for markets where there is a lot of uncertainty and volatility, such as a high level of geopolitical risk. Right now, there’s tension everywhere around the world. By having a buffer, investors get risk protection on the downside while still being invested in the market.

In summary, for financial advisors seeking to optimize client portfolios, integrating buffer ETFs can be a prudent strategy, particularly for those investors who want to remain in the market but are seeking downside protection and are willing to give up a little of the upside potential for that risk management.

DISCLAIMER

An investor that purchases Units of a Structured Outcome ETF other than at starting NAV 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.

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