How ‘Buffer’ ETFs Can Cushion a Major Market Selloff

A new exchange-traded fund (ETF) product that promises to limit investor losses is gaining popularity amid heightened market volatility and growing fears over a weakening global economy. Buffer ETFs, also known as defined-outcome ETFs, provide investors with a buffer against market losses in exchange for a cap on how much investors can profit on market gains, and they are seeing inflows even as other types of U.S. stock funds are suffering massive outflows, according to Barron’s.

Three such funds, all offered by Innovator Capital Management, and which track the price performance of the S&P 500 index, include the Innovator S&P 500 Buffer ETF (BJUN), the Innovator S&P 500 Power Buffer ETF (PJUN), and the Innovator S&P 500 Ultra Buffer ETF (UJUN). For investors looking for exposure to emerging markets, Innovator also offers its MSCI Emerging Markets Power Buffer ETF (EJUL).

Key Takeaways

  • Buffer ETFs experiencing inflows as other stock funds see outflows.
  • Offer investors protection against market losses.
  • The tradeoff of added protection is a limit on potential gains. 
  • Popular product amid volatility and global economic slowdown.

What It Means for Investors

For investors looking for stock-like gains but want to protect themselves against downside risks, especially in a more volatile environment, buffer ETFs fit that niche. However, the tradeoff for the benefit of protection is the acceptance of a limit on potential gains. Bigger buffers against losses come with correspondingly lower limits on gains.

For example, Innovator’s “Buffer ETF” provides protection against the first 9% of losses on the S&P 500, but caps gains at 16.45% (or 15.66% net of the expense-ratio fee of 0.79%). If the S&P 500 loses 12%, the total loss to the investor is just 3%, with the other 9% being absorbed by the ETF's built-in buffer. But the maximum upside available to investors is 16.45%.

The “Power Buffer” strategy offers protection against losses up to 15%, but caps gains at the lower threshold level of 10.52% gross gains (9.73% net of fees). Innovator’s “Ultra Buffer ETF” offers a range-style buffer, protecting against losses greater than 5% but less than 35%. The upside cap is 10.26% gross (9.47% net of fees). 

“We’re seeing really good participation on the first day of a new offering, so we know there’s pent-up demand and people are waiting to get involved when a new ETF is offered,” Innovator CEO Bruce Bond told back in June when it rolled out the tree “Buffer” ETFs that track the S&P 500 back in June. “We’re trying to make it as simple and straightforward for investors as we can.”

For investors, it’s important to realize that the buffer and cap are set on the fund’s release date for a one-year term, known as the outcome period. Thus, the timing of the investment matters. Any investment in a buffer ETF that occurs after the tracked index moves away from its initial starting value at the beginning of the outcome period will have a different effective buffer and cap than what is advertised. 

Innovator, currently the only provider of buffer ETFs, first introduced the funds in August 2018 and since that time they have amassed roughly $1.38 billion in assets. In August of this year, these ETFs saw a net inflow of $159 million while other types of U.S. stock funds saw outflows of $19.8 billion amid concerns over the health of the global economy. In the current economic climate, many investors are welcoming of structured funds that have built-in hedging mechanisms.

Looking Ahead

But despite recent optimism, some wealth managers are sceptical. “If investors maintain long-term horizons, historical data suggest that diversified portfolios of equities have little downside risk and, a majority of the time, have compelling returns,” argues Michael Chasnoff, CEO and founder of wealth management firm Truepoint Wealth Counsel. “Given that the downside risk is limited over time, the need to hedge this risk and pay for it is unnecessary.”

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