Buffer ETFs promise equity returns with built-in downside protection. But a closer examination shows a mixed picture between a plausible concept and a sobering performance record.
• Buffer ETFs combine a stock portfolio with an options structure to protect against losses
• The upside potential is capped by sold call options
• Several UCITS-compliant buffer ETFs with expense ratios around 0.50 percent are available in Europe
How buffer ETFs cushion losses and cap profits
Buffer ETFs, also known in the industry as defined outcome funds, combine a stock portfolio with an options structure. The goal is a predefined corridor: up to a certain loss, the portfolio is protected by put options, but the upward potential is capped by sold call options. The investor exchanges a portion of possible profits for a defined loss limitation.
The first UCITS-compliant buffer ETFs were introduced in Europe. The strategies work with rolling option hedges and clearly defined outcome periods. Losses within certain ranges should be cushioned, while at the same time price gains are only possible up to a set cap. Many of the products have ongoing cost ratios of around 0.50 percent. Some strategies are based on the S&P 500 and systematically combine the stock market with put and call options.
Why the manufacturers justify the promise with the 60/40 crisis
The reason given by many providers is based on the weakness of classic 60/40 portfolios: in phases of rising interest rates, stocks and bonds can come under pressure at the same time, which reduces the diversification effect of mixed portfolios. Buffer ETFs are therefore not intended to replace the bond position, but rather to structure the equity allocation in a more defensive manner.
Providers often advertise a lower fluctuation range while simultaneously reducing their participation in price increases. Buffer ETFs are positioned as a simpler alternative to structured products, which are intended to offer investors a form of loss limitation. The approach is aimed primarily at investors who fluctuate between a very low equity quota and an unsecured full investment.
The quantitative dissenting voice: AQR sees no added value in the data
In contrast, there is criticism from the quantitative asset management industry. As Clifford Asness and Daniel Villalon of AQR Capital Management explain in the “Buffer Madness” analysis, a follow-up to the study “Rebuffed: A Closer Look at Options-Based Strategies,” 86 percent of 103 U.S. funds examined in the Morningstar categories of Defined Outcome, Derivative Income and Equity Hedged delivered lower cumulative returns than a simple combination of stocks and cash, each adjusted to the average stock beta of the fund was scaled. In 70 percent of these funds, the maximum drawdown was also worse than in the stocks-plus-cash comparison. The products not only delivered lower returns, but in many cases also failed to fulfill their actual promise of limiting losses.
The peer-reviewed in-depth look at these findings later appeared under the title “Rebuffed: An Empirical Review of Buffer Funds” in the Journal of Portfolio Management. The findings continued to worsen over longer periods of time. AQR explains the pattern with three structural weaknesses of option-based strategies: the recurring purchase of put options incurs high premium costs, the expiration of the options forces a constant reissue at market prices, and the actual protection is often weaker than a reduced equity allocation combined with cash.
What investors should consider before buying
For investors who are considering buffer ETFs as an addition, concrete test points can be derived from this. First, the relationship between buffer and cap: The cap of a buffer ETF is reset at the beginning of each outcome period and depends on the option price level. In strong bull markets with returns above the current cap, the investor therefore misses out on any profits above this threshold. Secondly, the cost structure: With ongoing expense ratios of around 0.50 percent, many buffer ETFs are well above typical passive world equity ETFs, which can weigh on the net return in the long term.
Thirdly, the question of the standard of comparison. Anyone considering a buffer ETF should not compare it with a pure 100 percent equity allocation, but rather with a beta-equivalent combination of a stock ETF and a money market or short-term bond position. The AQR analysis shows that this simpler mix was superior in many cases in terms of both returns and drawdown limitation. For investors with high loss aversion, a buffer ETF can still represent a justifiable addition, provided the cap logic and cost structure are consciously accepted. Anyone who controls asset allocation strictly according to risk-return criteria will usually find a more transparent and cheaper solution in a world stock ETF combined with cash or short government bonds.
Dominik Maier, editorial team at finanzen.net
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