Everything Investors Should Know About Buffer ETFs

In recent years, buffer ETFs have gained traction among investors, especially given rising market volatility and uncertainty in the political and geopolitical realm. Given this backdrop, it makes sense that buffer ETFs would catch many investors’ eyes.

Buffer ETFs are sometimes marketed as a more palatable middle ground between stocks and bonds—they offer some downside protection with the ability to participate in growth. Also known as defined outcome or outcome-based ETFs, they are structured using options strategies—mainly combinations of puts and calls—to create a preset risk-reward profile. Different buffer ETFs can each have unique ‘cap and buffer,’ depending on prevailing market conditions and interest rates.¹

In short, buffer ETFs are built to absorb a set portion of losses—usually up to 10% or 15%—over a specified time frame, typically a year. In return, investors trade away some of the upside, often capped at relatively modest levels.

Again, as market uncertainty lingers and memories of volatility in 2020 and 2022 remain fresh, the idea of shielding a portfolio from sharp drops—while still participating in some growth—sounds like a win-win.

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Positioning Your Investments for a Volatile Market

“Don’t put all your eggs in one basket.” It’s a classic proverb, and for good reasons. Diversifying your portfolio is one the most basic pieces of investing advice—but unfortunately, it’s also advice that too many investors ignore.

Zacks Advantage would like to help you ensure that your investments are properly diversified so that you can avoid the risks of over-concentration in any particular asset class. That’s why we’re offering our free guide, Is Your Investment Portfolio Actually Well-Diversified? ²

Act now to get the basics of diversification, including:

• Why the average investor’s returns lag behind almost every investment category
• 4 myths of a diversified portfolio
• How to create a truly well-diversified portfolio

Learn more with our free guide, Is Your Investment Portfolio Actually Well-Diversified? ²

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The growing popularity of buffer ETFs isn’t just a fluke—it’s a reflection of investor psychology. After experiencing whiplash from market swings, many are looking for ways to stay invested while feeling a little safer. Buffer ETFs tap into that desire by offering a clear, rule-based strategy that promises to cushion the blow in bear markets.

Buffer ETFs have also emerged during a period when traditional “safe” assets like bonds faced their own challenges. Rising interest rates hurt bond prices, and inflation chipped away at real returns. In this context, a product that promises some downside protection and upside potential—while avoiding the duration risk of bonds—can sound like an attractive solution.

At their best, buffer ETFs can play a unique role in certain portfolios:

• Behavioral discipline: Knowing there’s a cushion can help nervous investors stay invested during volatile markets.
• Defined outcomes: The rules are clear—there’s no guessing what you’re exposed to or not.
• Tax efficiency: Since they’re ETFs, they can be more tax-efficient than similar strategies in mutual fund form.

These features are genuinely appealing—especially for investors prone to emotional investing. But there are trade-offs, and underneath all of the benefits lies a more nuanced reality.

The first is forgoing long-term upside potential. With buffer ETFs, investors give up potentially significant returns in return for the downside protection. In long bull markets, this can mean hitting a ceiling of upside potential as the market runs.

Timing is also important. ETFs reset annually, meaning the buffer and cap apply only during the term. If you buy mid-cycle, your outcome could be drastically different from what’s advertised, and if you miss the term window or sell early, your results could be unpredictable.

The overarching concept of buffer ETFs is intuitive, but the mechanics—especially with regard to options pricing, market volatility, and interest rate impacts—can get complicated. Before investing, it’s important to familiarize yourself with all of the fine print much like you would any other financial product, like insurance or annuities.

Finally, there’s a cost consideration. Buffer ETFs carry higher expense ratios than traditional index funds, which when added to an investor’s capped upside, could translate to underwhelming long-term performance.

Bottom Line for Investors

None of this is to say buffer ETFs are inherently flawed. Like many financial instruments, they serve a purpose when used correctly and with full understanding. For certain conservative investors or those seeking very specific outcomes during uncertain times, they may be a useful tactical tool.

But before jumping in, investors would be wise to look past the headline features and understand the mechanics. A balanced, more conservative portfolio isn’t just about buffers—it’s about choosing an asset allocation that provides the type of risk adjusted returns required to reach your long-term goals.

Most investors can get where they need to go over the long term by owning a diversified portfolio of stocks and/or ETFs. In fact, “diversify your portfolio” is one the most basic pieces of investing advice. Sadly, in our experience many investors still put all (or most) of their eggs in one basket.

At Zacks Advantage, we strive to help every investor properly allocate their assets. In fact, we’ve put together a helpful guide to help you understand the basics of portfolio diversification, including:

• Why the average investor’s returns lag behind almost every investment category
• 4 myths of a diversified portfolio
• How to create a truly well-diversified portfolio

Get our free guide, Is Your Investment Portfolio Actually Well-Diversified? ³, to learn how to create a truly diversified portfolio.

Download our FREE Guide³

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¹ Nasdaq. October 27, 2024.

² Zacks Investment Management may amend or rescind the Is Your Investment Portfolio Actually Well-Diversified? guide offer for any reason and at Zacks Investment Management’s discretion.

³ Zacks Investment Management may amend or rescind the Is Your Investment Portfolio Actually Well-Diversified? guide offer for any reason and at Zacks Investment Management’s discretion.

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