Why Buffer Funds Haven’t Escaped the Bear Market
From: www.morningstar.com
This year’s brutal market has tested their downside protection.
Buffer funds—which promise to limit downside losses from equity market exposure while capping upside returns—have grown increasingly popular. By my count, there are now roughly 120 exchange-traded funds plus a handful of open-end mutual funds following this approach. [1] Since the first buffer products appeared on the scene in 2016, assets have grown to more than $14.5 billion.
The bear market in 2022 has tested their limits. While these funds have cushioned against some losses, they were still down more than 12.5%, on average, for the year to date through Sept. 30, 2022. That’s probably a disappointment for investors who hoped to capture upside returns without suffering too much on the downside.
What Buffer Funds Do
Buffer funds typically invest in a broad market index along with a standard options collar to limit downside risk. The idea is to provide a shock absorber against a certain level of market losses over a defined-outcome period (typically one year). The collar strategy involves selling call options (which limits upside returns) and using the proceeds to buy put options (which limits downside risk). Some of the more established ETFs, such as the Innovator Buffer series, have downside buffers ranging from 9% to 30%. In down markets, shareholders are only exposed to losses that exceed the buffer. Upside caps vary depending on the issue date and generally increase along with market volatility.
How Buffer Funds Have Held Up in 2022
This approach has had mixed results this year. On average, buffer funds lost about 12.7% for the first nine months of the year—about half as bad as the market overall. But the underlying results span a wide range. As shown in the chart below, a few funds suffered only mild losses so far this year, while the worst dropped nearly as much as the market benchmark. This wide range of results underscores the fact that universe of buffer funds isn’t monolithic. Depending on the product, investors are getting a different level of downside protection and upside participation, and those guardrails are in effect over a different time period (aka the “outcome period”). As mentioned above, buffer funds seek to protect investors from a certain level of losses, but shareholders are still exposed to losses beyond that point. As a result, every fund included in my test group posted negative returns for the year to date.
Defined-outcome funds have also delivered a wide range of results in previous bear markets. During the coronavirus-driven downturn from Feb. 19, 2020, through March 23, 2020, for example, losses on these funds ranged from about 13% to more than 40%.
The details behind how the buffers work are complicated. Because the buffer only applies to a specific outcome period, shareholders could still suffer losses over shorter periods. Buffer terms also vary by fund. While most funds are designed to cushion against all losses between zero and the buffer level, for example, Innovator S&P 500 Ultra Buffer ETF UAPR was designed with a buffer that only kicked in after the first 5% of losses (buffering losses between negative 5% and negative 35%). Shareholders who held the ETF for the one-year period ended March 31, 2020, therefore still lost 5.77% net of expenses.
The Upside-Down World of Buffer Funds
The fact that buffer funds can still lose money during the sharpest market downturns isn’t their only weakness. As I covered in a previous article, another drawback inherent in buffer funds is that they limit upside returns. As the U.S. equity market rallied in 2021, the Morningstar US Market Index finished the year with a 25.8% gain, but the average buffer fund gained only 9.9%.
This trade-off might be appealing for investors who are wary of losing money, but it’s at odds with how markets generally perform. Statistically speaking, markets tend to generate positive returns more often than not. Therefore, buffer-fund shareholders are more likely to sacrifice upside returns than benefit from downside protection. For many defined-outcome funds, the most likely statistical outcome is that shareholders end up with neither a benefit (in the form of limited losses) or a cost (in the form of limited upside returns). But the second most-likely outcome (depending on the specific cap level), is that shareholders end up foregoing some positive returns.
In addition, most buffer funds are linked to a price-based benchmark (such as the S&P 500 Price Index) that doesn’t include returns from dividend yields. That means during periods of positive returns, performance is guaranteed to trail the market even if returns aren’t high enough to hit the cap level.
Risk/Return Trade-Offs
Over longer periods, defined-outcome funds have delivered a decent, if not stellar, risk/return profile. There are only a handful of funds with three-year records, but those funds have generated lower returns than broad equity market benchmarks, while keeping volatility (as measured by standard deviation) significantly lower. Overall, though, risk-adjusted returns have lagged a simple 60/40 blend of stocks and bonds.
While they’re less expensive than structured notes, a similar type of product that often comes with hefty fees, most buffer funds and ETFs aren’t exactly cheap, either. The average expense ratio is about 0.8%, which seems pricey for a product that’s essentially an index fund with an option overlay. (Granted, options can be complex and intimidating for many investors, making it less likely that most do-it-yourselfers would want to replicate these products on their own.)
Conclusion
As I discussed in my previous article, these funds are often marketed to reluctant investors. By removing part of the uncertainty and downside risk inherent in investing, buffered products make it easier for beginning investors to take initial steps into the market. But as this year’s performance attests, they’re far from a panacea.
[1] For the purpose of this article, the buffer funds group includes funds that quantify downside protection and excludes funds with more general downside-protection mandates, such as bear-market, limited volatility, long-short equity, and other options-based offerings.
