Why investors should consider buffer ETFs

Slowing economic growth is causing investors to be more cautious with their portfolios as they search for solutions to complement equity holdings. One solution could be buffer exchange-traded funds (ETFs), which provide diversification and downside protection.

Chris McHaney, Portfolio Manager, ETFs, at BMO Global Asset Management (BMO GAM), explains how buffers work in a variety of markets to provide a hedge against volatility.

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Q: How do buffer ETFs work?

Chris McHaney: Buffer ETFs are built through an option overlay strategy. There are a few steps involved. First, we get that broad equity market exposure. At BMO GAM, we invest in the S&P 500, which has the most liquid options market, and that’s what makes it very efficient to run a strategy like this. That broad equity market exposure is combined with a protective option overlay that provides protection against the first 15% of losses over a one-year period. The full benefit of that buffer, of that protection, is achieved when that option matures at one year. BMO launches a new buffer ETF every three months to provide investors with different options based on market conditions. For instance, we launched ZOCT in October 2023, ZJAN in January this year, and, more recently, ZAPR in April.

These are all invested in S&P 500 hedged to Canadian dollars equity index ETF with that first 15% of losses protected against any market loss. The way to pay for that level of protection is to cap the upside potential in the portfolio. Say the market continues to rally strongly. At some point, the buffer ETF investor stops participating in that growth. So, what they’re getting is participation in the markets with protection against downside risk.

By launching one of these buffers every three months—ultimately having four of them in the market at a time in any given year—investors will have a few different options. So, at any particular time, one of those strategies may be attractive to them in terms of risk control.

“Buffer ETFs are important tools for investors due to factors such as stock/bond correlation, and the behavioural aspect of investor psychology.”

Q: Why is a buffer ETF a good solution in the current market?

CM: Many experts and analysts have noted that there is an expectation of slowing economic growth, particularly in Canada[1]. Add to that the rising concentration of a few stocks that are

driving the market[2], which increases idiosyncratic risk for investors. Finally, there is a rising correlation between stocks and bonds, making it less optimal to rely on fixed income investments for risk control. Pulling all these things together, it can make investors more defensive or cautious when it comes to equity investments. Buffer ETFs provide explicit protection against downside risk in equity portfolios, making them a more effective hedge than fixed income investments.

Q: How can a buffer ETF complement core equity positions?

CM: Buffers add risk control and protection against downside risk while still maintaining equity exposure. For instance, a slightly cautious investor can take some of their equity allocation and put it into a buffer ETF. An even more cautious investor can take a larger allocation of their equity portfolio and put a larger portion of that into a buffer ETF. Either way, a buffer ETF adds a higher level of protection into their portfolio.

Q: How are BMO’s buffer ETFs performing?

CM: There aren’t many similar solutions in the market right now. Our buffers are providing a smoother return path compared to the market. That’s because each buffer has a defined level of protection, so you won’t go as low as the market. And, if the market rallies, then the upside cap will cause the buffer to lag. Over time, the buffer ETF will trend toward that structured outcome that is put in place as it gets closer to the end of that one-year period.

Q: Why is a buffer an important tool going forward?

CM: Buffer ETFs are important tools for investors due to factors such as stock/bond correlation, and the behavioural aspect of investor psychology. It’s hard to time the market. Emotions can cause investors to sell when the market is down. Studies have shown that when it comes to gains and losses, the pleasure you get from a 10% gain in your portfolio is less than half of the pain you feel from a 10% loss.[3] So, having that hedge naturally in place in your portfolio helps you to mitigate downside risk, allowing you to sleep better at night.

DISCLAIMER

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

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[1] www.conferenceboard.ca/insights/canadas-economy-enters-a-slowdown/, www.imf.org/en/Publications/WEO/Issues/2023/10/10/world-economic-outlook-october-2023

[2] Watch Concentration of the Bull Market – Bloomberg Bull Market – Bloomberg

[3] Prospect Theory: An Analysis of Decision Under Risk, Daniel Kahneman and Amos Tversky, Econometrica, 1979.