Conversations between clients and advisors must be a heck of a lot easier these days compared to a year ago, right? After all, stocks continue to post impressive gains in 2023 — the Nasdaq even notched its best January-through-July stretch on record. What’s more, since the middle of the second quarter, other areas of the stock market, not just the “Magnificent Seven,” have participated in the upside move. 

Of course, bonds continue to be rocky, and now there are renewed fears of even loftier interest rates that have led to volatility in fixed income along with multidecade highs in the correlation between equities and Treasuries. Overall, though, a traditional 60/40 portfolio is having a comeback year. Through July, that basic allocation was up by about 13% for 2023. 

Better Days Ahead? Or Is Volatility Lurking?

Then we can look at the macro landscape. The U.S. economy might just skedaddle its way past a possible recession. Consumers continue to spend (and they have turned more confident in both their present situation and forward prospects), although it seems like the majority of their discretionary dollars have been flowing to Taylor Swift, not necessarily small businesses! Wage gains are stout, too, finally outpacing inflation on a monthly basis as the unemployment rate is not far from its lowest point since the 1960s. 

Amid Strong Markets, Rattled Investors Are Flocking to Buffered Funds

Everything is pretty much back to normal for wealth managers, then? Not so fast. It turns out that while the S&P 500 remains below its all-time high, notched more than 18 months ago, one nascent ETF space continues its torrid bull run. 

Buffered ETFs, also known as defined-outcome funds, have raked in more than $5 billion this year (through July), according to Eric Balchunas, senior ETF analyst at Bloomberg. “That’s a 23% organic growth rate for the emerging $28 billion fund category,” Balchunas said. And there is more big news in the world of buffered funds. ETF megaplayer Blackrock is getting in on the game, so it’s reasonable to assume that more retail interest will follow. 

Managing Risk With Elegant Simplicity

For background, buffered ETFs are designed to offer investors a diversified or focused strategy with some level of downside protection while still allowing them to participate in a portion of the market’s upside return. The ETFs generally use options strategies to create a buffer against a certain percentage of losses on an index or underlying asset. In exchange for that benefit, upside returns are commonly capped at a predetermined percentage. 

Defined-outcome ETFs are sometimes considered a subset of buffered ETFs in that they are like structured products with the objective of providing their holders with returns in a predefined range. The whole idea is to limit losses to an amount an investor can stomach without sacrificing too much upside potential. In the end, both buffered ETFs and defined-outcome funds can be effective tools to manage risk, particularly for clients who can’t go all-in on the S&P 500 or Nasdaq.

2022’s Weak Stock Market and Dreadful Bond Returns Laid the Bullish Foundation for Buffered ETFs

It made sense a year ago that these seemingly defensive strategies were the talk of Wall Street. Advisors with whom we partner very much appreciated being able to include them not only in client portfolios but also in conversations. We all know that the best portfolio is one that a client can forge ahead with even during harsh bear markets. Given that we, as human beings, loathe uncertainty and crave to know what’s around the bend, defined-outcome ETFs hit on our survival instincts honed over the eons. Unfortunately, navigating financial markets is something we just are not wired for. Buffered funds may help bridge that behavioral gap.

Tale of the Tape: Money Flows Persist Into Buffered ETFs

Thus, when sitting down with, say, a retired couple concerned about volatility, rising interest rates, inflation, and falling stock prices during much of 2022, bringing up the benefits of defined-outcome strategies made perfect sense. As a result, advisors added $5.7 billion to Innovator’s ETF lineup alone last year — a record annual sum. The Chicago-based company was said to be the fastest-growing ETF issuer. It really was the perfect setup for Innovator: The S&P 500 lost 18% (with dividends included) while investment-grade domestic credit and Treasuries endured their worst year on record (down 13% total return), all while both the VIX and bond market volatility hovered at relatively elevated levels.

2023’s Relief Rally Fooled So Many Experts

A new year brought about a new market narrative, though. Late last year, nearly all sell side market strategists were bearish on what 2023 would hold, but January got off to a hot start for both equities and fixed income. The SPX was up 8% total return while the aggregate bond market clawed back a portion of its 2022 losses, as well, rising 4%. Jitters came about in February and March, highlighted by regional banking turmoil, but unlike last year, financial markets were resilient. Toss a bit of artificial intelligence froth in the mix and one of the best first halves on record was brewed up.

“Buffered ETFs Will Lose Interest When Stocks Recover.” Nope!

Even with client portfolios recovering from hits taken last year, defined-outcome ETFs stand strong today. New contenders are entering the ring and retail clients are packing the proverbial arenas to check out what the ETF category has to offer amid this new regime of stronger-performing stocks and bond yields that are no longer down for the count. 

When Morningstar issued its July ETF flow update, it turned out that investors are continuing to get in on the game. After another $5 billion-plus flowed into the space during the first half of 2023, July featured another massive $1.3 billion inflow. So, despite a bull market, the category grew at a 25.3% organic rate year-to-date through July. 

Stocks & Bonds Ebb and Flow, But Human Psychology Endures

The fact is that Main Street investors are still nervous about their money and feel compelled to escape being completely beholden to the whims of the indexes. Are people feeling better, more hopeful? Absolutely. Are we in a better place today to get clients young and old to their money goals? A wholehearted yes. Could things still go wrong? Maybe. Is there something you as a wealth manager can do? You better believe it.

What’s ideal about buffered ETFs is that they are relatively easy to explain to investors of all knowledge levels. There’s limited downside risk and upside gains are constrained. This bracketed performance feature offers investors the certainty they crave, and the ETF wrapper may make them tax efficient with a reasonable cost compared to taking a DIY approach, which would include trading options and finding the time to execute their own strategy. There’s beauty in simplicity here.

The Bottom Line

Advisors are feeling better these days. Stocks are up big in 2023 despite a continued dicey bond market. Portfolio values have swelled, recouping much of last year’s declines. And with home values creeping back up, household net worth has been on the rise, too. Yet, for retail investors who still crave certainty and downside protection for their financial asset, why not consider including buffered ETFs in your investment offering? You may discover that more clients than you might have thought would like access to this type of protective investment for a slice of their allocation.

Buffered ETFs’ are different from more typical investment products, and the funds may be unsuitable for some investors. It is important that investors understand the investment strategy before making an investment. Investment involves risk, including possible loss of principal. There is no guarantee the funds will achieve their investment objectives.