The S&P 500 was down more than 23% through the end of September, marking the fourth-worst start to a year since 1928, as economic uncertainty and market volatility continue to weigh on markets. The CBOE Volatility Index (VIX), which measures expected one-month price changes in the S&P 500, has generally ranged from near 20 to the mid-30s throughout 2022, a sign that bigger daily stock market swings are expected versus the relative calm seen in 2021. For perspective, the long-term average VIX reading is near 20.

Volatility Hits Client Portfolios Hard

Investors feel these wider-than-average value changes in their investments, too. Unfortunately, most of the moves have been to the downside as both stocks and bonds have fallen for three consecutive quarters. What has caught the eye of Main Street investors this year amid so much uncertainty? A new type of exchange-traded fund (ETF): Buffered ETFs.

A Portfolio Solution to Manage Risk

Buffered ETFs are designed to help mitigate portfolio risk by limiting downside exposure while tracking an index like the S&P 500. In exchange for protection on the way down, the funds’ upside is capped at a stated level. Options are used to manage the risk. The term “buffer” refers to the amount the index the ETF tracks can decline before the ETF’s holder experiences losses. “Cap” is the predefined maximum gain potential over the investment period.

An Experienced Team Helping Advisors

Halo Investing is all about offering advisors protective investment solutions to help their clients sleep at night while keeping them on track to achieving their financial goals. We have also been a long-term player in the buffered ETF space – even before the popularity boom that has taken place over the past two-plus years. Morningstar Direct data show that total assets under management in options-trading funds, which include buffered ETFs, has exploded from less than $21 billion in March 2020 to more than $55 billion as of the end of July 2022.

How Buffered ETFs Can Fit In

Buffered ETFs are also known as “defined-outcome” funds in that prospective investors know what the upside and downside percentages will be prior to investing. However, they can still be tricky products to understand and explain to clients.

Halo’s online platform and subject-matter experts equip advisors with the resources they need to not only incorporate these funds into their investment offerings but also to have conversations with retail investors about how buffered ETFs fit into financial plans. We also have the analytics and portfolio tools needed to compare fund holdings and track performances. You can also set up custom notifications and analysis settings.

Buffered ETFs: Funds Featuring Downside Protection with Defined Upside Participation 

All an advisor must understand about buffered ETFs are four key traits:

1. The fund tracks the price returns of an index. What’s great about buffered ETFs is that an advisor doesn’t have to learn about a whole new sub-asset class. If you know the S&P 500, Nasdaq 100, or Russell 2000, then you are already familiar with buffered ETFs’ market exposure.
2. They have downside protection. Each buffered fund available on Halo’s marketplace will have a stated buffer amount of downside protection. More aggressive products might feature a smaller buffer while more conservative products will have a larger downside protection percentage. Put options are bought within the ETF to create the buffer.
3. There is an upside cap on gains. To offset the purchase of put options used to limit losses, call options are sold on the reference index. In total, four layers of options are transacted to craft a buffered fund: long calls to create a synthetic 1-to-1 index exposure, long higher-strike puts, short lower-strike puts (creating a put spread to the targeted buffer percentages), and short high-strike calls to set the ETF’s upside cap.
4. Maturity is usually 12 months. While investors can get in and out of buffered ETFs at any time they are traded after issuance and before maturity, they must understand that, unlike traditional ETFs, there is a maturity date on the buffer and cap since options have a finite life. The upshot is the holder can simply keep the ETF, as it will roll into new options with the same buffer level and term length, but with a new upside cap.

The Inner Workings

Buffered ETFs are constructed using options. That’s what makes these types of funds flexible in their payoff profiles. We find some of the most popular downside protection levels are 10% and 20%. It’s important to know that the ETF’s share price will, of course, move as the market fluctuates. So, while there are known payoffs at maturity, getting to that point will still feature changes in the fund’s net asset value. Also, options only offer price returns on the underlying index, so there is no dividend income.

How Advisors Use Buffered ETFs in Client Portfolios

Halo finds that buffered funds can be particularly appealing to investors nearing or just entering retirement. Why’s that? Those critical years are when the sequence of returns risk is at its highest. A big market decline during that period might result in a retiree’s investments depleting sooner than planned. Holding a fund that is specifically designed to weather volatility and downside in the stock market can help reduce that risk.

Buffered ETFs can also be put to work to help meet a client’s nearer-term financial goals. Rather than accepting a high degree of market risk or letting money sit in cash, an advisor might choose a particular combination of downside protection and upside protection to get a client invested in a risk-conscious way while still increasing the probability that the client can reach their financial objectives.

The Bottom Line

Buffered ETFs are built to reduce portfolio risk, diversify a traditional asset allocation, and can even be used to put cash to work in a risk-managed way. Halo Investing has offered these funds on our award-winning marketplace for many years, while buffered ETFs have just recently exploded in popularity. Advisors can partner with Halo to get their clients on board with low-cost protective investment solutions amid this volatile investing environment.

Please see our Halo Disclosure Page for important disclosures.