One of the best ways for ETF investors to beat the market this year has been to play it safe. So-called buffer ETFs, an options-based product that allows investors to protect against losses in exchange for capping potential upside, have handily beaten the S & P 500 in 2022, even with the recent rebound for the market. For example, the Buffer series offered by Innovator ETFs shows consistent outperformance for the funds tied to the SPDR S & P 500 ETF Trust (SPY) . The Innovator U.S. Equity Buffer ETF for January (BJAN) , which rebalanced right before the market hit record highs, has fallen 5.8% this year compared with 10.1% for the SPY. The August fund (BAUG) , which rebalanced a few weeks ago, is down just 3.7% year to date. They have proven popular as well, with Innovator bringing in more than $1.2 billion of inflows to its defined outcome products in the second quarter, according to the firm. CEO Bruce Bond said that the market volatility motivated some previously interested investors and advisors to jump into the products. “All of a sudden, when the market gets shaky or really becomes an unknown, they come back and say, okay, I’m going to get involved here. I’m going to use this in a more active way,” Bond said. The basic structure of the funds from Innovator and competitors like First Trust, goes like this: the ETF gains exposure to the market through a deep in the money call option on a broad ETF, like SPY. Then, the fund implements a put spread to protect against downside. For example, the put spread could consist of buying a put at the money and then selling a put 10% below the money. This would mean that, for the first 10% of a decline in the underlying asset, the fund would theoretically take no losses. To help pay for this position, the fund then sells another call option, which creates the “cap” on upside gains. The exact levels of protection and cap can differ by fund. For example, Innovator offers funds with downside protection at 9% and15%, and 5% to 35%, in its main Buffer ETF series, and has other variations as well. First Trust’s offerings include buffers of 10% and 25%, among other products. The FT Cboe Vest U.S. Equity Buffer ETF – January fund is down less than 1% this year. Source: Innovator, First Trust Ryan Issakainen, ETF strategist at First Trust, said that the Buffer ETFs can function as a substitute for a traditional 60-40 portfolio, but this year, with bond yields spiking, the buffer ETFs have proven to be even more protective than that old-school strategy. Issakainen said the funds can also serve as a counterweight to riskier bets elsewhere for an investor. “They can pair up a less volatile buffer ETF with some more volatile opportunistic trades,” Issakainen said. How to invest in the funds One quirk of these products is that, because they are based on options and do not hold the underlying index, the funds do not perfectly track the market even when in between the buffer zone and the cap. Bond said that the funds “rhyme the market” but typically see it lag the market on the upside and the downside before its defined rebalancing period. Innovator offers funds for each month that hold 12-month positions. “An option has time value at the beginning, so it doesn’t move around just like the market. But the closer that option gets to expiration, the more market-like it becomes,” Bond said. This phenomenon can cause the funds to show worse-than-expected returns outside of their rebalancing periods. Morningstar research analyst Lan Anh Tran said that in order for investors to get the advertised benefits of the funds, it is best to buy and hold them throughout their defined periods. “The defined outcome comes with the options expiration. So if you can, hold it through the one-year holding period that a lot of these funds have, but if for any reason you need to pull out or you change your mind, there is no guarantee,” Tran said. The rebalancing period is also important because it can impact how much upside is left in a fund, with the rally for stocks in recent months taking a bigger bite out of the cap for funds that entered new options contracts near the market bottom. For example, the SPY has already blown past the roughly 2.4% cap of Innovator’s super conservative Defined Wealth Shield ETF (BALT), which rebalanced in July. However, one good thing for investors this year is that volatility makes the call option used to create the cap more valuable to the market. As a result, caps have gone up. The recently rebalanced August fund (BAUG) has a potential net return of 21.66%, while the 11-month old September (BSEP) fund can return just 12.11%. “It’s significantly higher than it was this time last year. I think volatility is a good thing for these caps. When the market’s volatile, the caps tend to expand,” Bond said.
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