Can buffer ETFs fill the gap between cash and equities?

A different method to achieve downside protection has made its way to UK shores following success in the US. The asset management industry is hoping that advisers embrace buffer ETFs to help protect clients’ money and to provide enough upside to beat inflation.

Buffer ETFs, also known as defined outcome products, aim to give investors some protection against stock market falls while still allowing them to benefit from rising markets, up to a certain limit.

Think of a caterpillar rollercoaster ride at a theme park where the biggest movements are far less dramatic than a ‘grown up’ rollercoaster. A buffer ETF is like a caterpillar ride – you can still get some thrills and enjoyment but with the knowledge that your heart isn’t going race.

They come in different shapes and sizes. Some will offer protection against big losses over a 12-month period but only marginal upside. Others will offer less protection on the downside but much more on the upside.

For example, a buffer ETF might protect investors against the first 15% of any loss over the subsequent 12 months, in return for any gains being capped at 8%. If markets fall by more than 15%, investors still lose money.

No free lunch

The downside protection is not free. Investors effectively pay for it through a combination of capped returns and higher charges than a traditional passive index fund.

The level of upside potential or downside protection is set at the point of issuance. The ETFs trade on the market, so anyone buying partway through the 12-month period needs to understand what level of protection or upside potential they have left. The experience of someone buying later can be materially different.

Certain asset managers have quarterly buffer ETF issues so that advisers and their clients don’t have to wait long until the next one is out, rather than them buying an existing one post-launch.

There is anecdotal evidence that advisers in the US are mainly using buffer ETFs for clients in retirement, as well as for cautious investors and those sitting on large cash balances who don’t want to take excessive risks with equities. This makes perfect sense once you understand what the products are designed to achieve.

Structured products under a new name?

There might be some scepticism towards buffer ETFs as they are remarkably similar to structured products, which tend to provoke a love/hate reaction from the adviser community.

Structured products can be hard to explain to clients, the upside is limited, fees can look expensive, and they can lack liquidity – which is an issue if a client wants their money before the products mature.

Buffer ETFs aim to address some of these issues through greater liquidity, improved transparency, lower issuer credit risk and easier access via investment platforms. Those could be the winning factors that help win over structured product sceptics. Some advisers might already use structured products and find the new breed of ETFs to be just as useful.

It’s fair to say that certain advisers may question whether buffer ETFs solve a problem that can already be addressed through asset allocation. Rather than sacrificing upside through a capped-return structure, they may prefer to reduce equity exposure or use multi-asset portfolios.

Interesting timing to look at buffer ETFs

The biggest opportunity for buffer ETFs may not be replacing existing equity portfolios. Instead, they could help advisers move clients out of excessive cash holdings by offering some exposure to market gains while limiting a portion of downside risk.

Recent volatility in both bond and equity markets may increase interest in products promising a smoother ride, particularly for clients approaching retirement. Buffer ETFs might shine in falling markets but look less compelling when equities are rising strongly.

There are also some behaviour benefits to the products, particularly if markets pull back. It’s common to see investors worry or even panic at the sign of share prices flashing red on their screen. Knowing there is a buffer to protect some of the downside might help them to stay invested.

History suggests that market rebounds can happen when you least expect, so staying invested means that individuals wouldn’t miss the recovery, whereas those who stay on the sidelines in cash could lose out. Ultimately, it’s impossible to say whether buffer ETFs are the best thing since sliced bread or not. Their relevance all depends on what the individual wants to achieve and their own personal circumstances.

Past performance is not a guide to future performance and some investments need to be held for the long term.