One of the best ways ETF investors have beaten the market this year has been to play it safe. So-called buffer ETFs, an options-based product that allow investors to protect themselves against losses in exchange for potential upside, easily outperformed the S&P 500 in 2022 despite the market’s recent rebound. 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 US Equity Buffer ETF for January (BJAN), which rebalanced just before reaching record highs in the market, is down 5.8% this year, compared to 10.1% for the SPY. The August fund (BAUG), which was rebalanced a few weeks ago, is down just 3.7% year to date. They’ve also proven popular, with Innovator generating more than $1.2 billion in inflows into its defined outcomes products in the second quarter, according to the company. CEO Bruce Bond said market volatility motivated some previously interested investors and advisors to jump into the products. “Suddenly when the market falters or becomes really unknown, they come back and say, okay, I’m going to get involved here. I’ll use that more actively,” Bond said. The basic structure of the funds from Innovator and competitors like First Trust is as follows: The ETF gets access 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 movements. For example, the put spread might consist of buying a put at-the-money and then selling a put 10% below-the-money. This would mean that the fund would theoretically not suffer any losses for the first 10% of a decline in the underlying asset. To pay for this position, the fund then writes another call option, which creates the “cap” for upside gains. Exact levels of protection and caps may vary by fund. For example, Innovator offers 9% and 15% loss protection and 5% to 35% loss protection funds in its main series of Buffer ETFs, and has other variations as well. First Trust’s offer includes buffers of 10% and 25%. The FT Cboe Vest US Equity Buffer ETF – January fund is down less than 1% this year. Source: Innovator, First Trust Ryan Issakainen, ETF strategist at First Trust, said the buffer ETFs can act as a replacement for a traditional 60-40 portfolio, but this year given the rising bond yields, the buffer ETFs have proven to be balanced proved more protective than this old-school strategy. Issakainen said the funds can also serve as a counterbalance to an investor’s riskier bets elsewhere. “You can combine a less volatile buffer ETF with some more volatile opportunistic trades,” Issakainen said. How to invest in the funds A peculiarity of these products is that since the funds are options based and do not track the underlying index, they do not perfectly track the market even if they are between the buffer zone and the cap. Bond said the funds “rhyme the market” but typically see them lag the market up and down ahead of their defined rebalancing period. Innovator offers funds for each month holding 12 month positions. “An option initially has time value, so it doesn’t move like the market. But the closer the option gets to expiration, the more market-like it becomes,” Bond said. This phenomenon can result in the Funds posting worse than expected returns outside of their rebalancing periods. Morningstar research analyst Lan Anh Tran said that for investors to get the funds’ advertised benefits, the best way is to buy them and hold them over their designated timeframes. “The defined result comes with the expiry of the options. So if you can, hold it for the one-year holding period that many of these funds have, but if for any reason you have to exit or change your mind, there’s no guarantee,” Tran said. The rebalancing period is also important because it can affect how much upside potential remains in a fund, as the stock rally in recent months has hit the cap harder for funds that have made new options contracts near the market bottom.For example, the SPY already has the cap of around 2.4% for Innovator’s super-conservative Defined Wealth Shield ETF (BALT), which rebalanced in July.One good thing for investors this year, however, is that volatility is the call option used to create the cap , makes it more valuable to the market As a result, caps have risen The recently rebalanced August fund (BAUG) has a potential net return of 21.66%, while the 11-month-old September Fund (BSEP) can only return 12.11%. “It’s significantly higher than this time last year. I think volatility is a good thing for these caps. When the market is volatile, caps tend to expand,” Bond said.
