Unlock the Benefits of Buffer ETFs: A Shock Absorber for Your Portfolio

ByDan Kent Published On:

*This article is sponsored by BMO Exchange Traded Funds*

Investing in the stock market can be intimidating, especially with its inherent risks and volatility.

Innovative investment solutions like Buffer ETFs (Exchange-Traded Funds) are designed to offer a layer of protection against market downturns while still allowing for growth potential. This article will dive into what Buffer ETFs are, how they work, their advantages, and how they might be the right solution for you. Let’s dig in.

What Are Buffer ETFs?

A buffer or structured outcome ETF is a type of exchange-traded fund designed to provide investors with predefined outcome, such as specific level of downside protection and participation in market gains up to a cap. These ETFs use options strategies to create their structured outcomes.

Simply, buffer ETFs are built to provide a built-in cushion on the downside, while still providing some upside potential.

How Do Buffer ETFs Work?

Buffer ETFs use option contracts to achieve predefined investment outcomes. By using options, this provides a layer of protection with a cap on the market participation over the defined period.

The buffered zone and cap on market participation is set at the beginning of the period and only applies at the end of the specified outcome period. Investors trading the ETFs during the period can experience different performance from the stated downside buffers and upside cap1.

In essence: Buffer ETFs offer a trade-off: protection against market losses in exchange for a cap on potential gains, all defined within a specific period.

Let’s Break a Buffer ETF Down:

There are three main components within this solution that an investor should be aware of:

Buffer Protection: The buffer is the amount of downside protection the ETF offers. For example, a 10% buffer means that if the reference index the ETF tracks falls by 10% or less during the investment period, the investor won’t incur any losses. If the market falls by more than 10%, the investor will only bear the losses exceeding that buffer.

Cap on Gains: To provide this downside protection, Buffer ETFs employ an options strategy which caps the potential upside returns. This means that if the underlying index performs exceptionally well, the investor’s gains will be limited to a predetermined maximum percentage.

Outcome Period: Buffer ETFs have a specific outcome period, typically one year. The buffer zone and cap on market appreciation is set at the beginning of the period and only applies if an investor holds for the full period.  At the end of this period, the protection and cap are reset, and new levels are established based on current market conditions.  

Investors trading the ETFs during the period can experience different performance from the stated downside buffers and upside cap.

An Example of a Buffer ETF

Consider a Buffer ETF that tracks the S&P 500 with a 10% buffer and a 15% cap over a one-year period. Here’s how it would work in different scenarios:

Market Rises by 20%: The ETF would deliver a return of 15% due to the cap.

Market Rises by 10%: The ETF would deliver a 10% return.

Market Falls by 5%: The ETF would deliver a 0% return, absorbing the loss.

Market Falls by 15%: The ETF would incur a 5% loss, as it absorbs the first 10% of the drop.

Advantages of Buffer ETFs

Downside Protection: The primary advantage of Buffer ETFs is the cushion they offer against market downturns. This feature can provide peace of mind for investors, especially during volatile market conditions.

Predictable Outcomes: With Buffer ETFs, investors have a clear understanding of their potential gains and losses within the outcome period. This predictability helps in better planning and aligns with specific financial goals.

Ease of Access: Buffer ETFs trade on major stock exchanges like regular ETFs, making them accessible to individual investors without needing a specialized account or paying high fees.

Diversification: These ETFs can provide exposure to a broad market index while mitigating some of the risks associated with direct stock market investments.

Why Buffer ETFs Now?

Given where we are in the economic and political environment, investors may want equity exposure but may not want to take full market risk. This could be someone in or near retirement or a more risk averse investor. This strategy can help cushion their overall volatility and reduce the daily ups and downs.

Other reasons can be the increasing concentration of the magnificent seven in the S&P 500, as well as the consideration beyond traditional fixed income as diversifying your portfolio becomes pertinent to all investors.

Who Should Consider Buffer ETFs?

Buffer ETFs can be suitable for a variety of investors, particularly those who are:

  • Investors seeking equity exposure with some capital protection.
  • Risk-Averse: Investors who are wary of market volatility and want to mitigate potential losses without completely forgoing market exposure.
  • Retirees or Near-Retirees: Individuals approaching or in retirement who need to protect their capital while still seeking growth opportunities.
  • Long-Term Planners: Those who appreciate the predictability of defined outcomes for better financial planning.

Why buy these ETFs?

  • Smoother Ride: Protect against market declines and participate in market appreciation up to a cap.
  • No options expertise required: Traditional ETF that trades on the exchange
  • No upfront commissions: As opposed to other structures, ETFs are ideal for fee-based and discretionary accounts
  • No use of leverage: Outcomes generated through a mix of equities

Conclusion

Buffer ETFs offer a compelling investment option for those looking to protect against market downturns while still participating in market gains, albeit with a cap. They provide a balance between risk and reward that can be appealing to risk-averse investors, retirees, and those with specific financial goals.

BMO’s suite of Buffer ETFs provides a variety of options, to target specific outcome periods. However, it’s essential to fully understand their structure, benefits, and review the cap/buffer information before investing. By doing so, investors can make informed decisions and potentially enhance their investment strategy with the added security of Buffer ETFs.

To learn more about BMO’s suite of Buffer ETFs visit: BMO Structured Outcome ETFs – ETF Market Insights

1 Within the period, values will depend on the market, intrinsic2 and time value3 of the options.

2 Intrinsic value refers to the difference between the current price of the underlying security and the strike price in the option contract.

3Time value reflects an additional premium that investors are willing to pay for the time left on the option contract; typically, the time value of an option decreases as the contract approaches expiry.

This article is for information purposes. The information contained herein is not, and should not be construed as, investment, tax or legal advice to any party. Particular investments and/or trading strategies should be evaluated relative to the individual’s investment objectives and professional advice should be obtained with respect to any circumstance. An investor that purchases Units of a Structured Outcome ETF other than on the first day of a Target Outcome Period and/or sells Units of a Structured Outcome ETF prior to the end of a Target Outcome Period may experience results that are very different from the target outcomes sought by the Structured Outcome ETF for that Target Outcome Period. Both the cap and, where applicable, the buffer are fixed levels that are calculated in relation to the market price of the applicable Reference ETF and a Structured Outcome ETF’s NAV (as Structured herein) at the start of each Target Outcome Period. As the market price of the applicable Reference ETF and the Structured Outcome ETF’s NAV will change over the Target Outcome Period, an investor acquiring Units of a Structured Outcome ETF after the start of a Target Outcome Period will likely have a different return potential than an investor who purchased Units of a Structured Outcome ETF at the start of the Target Outcome Period. This is because while the cap and, as applicable, the buffer for the Target Outcome Period are fixed levels that remain constant throughout the Target Outcome Period, an investor purchasing Units of a Structured Outcome ETF at market value during the Target Outcome Period likely purchase Units of a Structured Outcome ETF at a market price that is different from the Structured Outcome ETF’s NAV at the start of the Target Outcome Period (i.e., the NAV that the cap and, as applicable, the buffer reference). In addition, the market price of the applicable Reference ETF is likely to be different from the price of that Reference ETF at the start of the Target Outcome Period. To achieve the intended target outcomes sought by a Structured Outcome ETF for a Target Outcome Period, an investor must hold Units of the Structured Outcome ETF for that entire Target Outcome Period. BMO Buffer ETFs seeks to provide income and appreciation that match the return of a Reference Index up to a cap (before fees, expenses and taxes), while providing a buffer against the first 15% (before fees, expenses and taxes) of a decrease in the Reference Index over a period of approximately one year, starting from the first business day of the stated outcome period. Commissions, management fees and expenses all may be associated with investments in exchange traded funds. Please read the ETF Facts or prospectus of the BMO ETFs before investing. Exchange traded funds are not guaranteed, their values change frequently and past performance may not be repeated. For a summary of the risks of an investment in the BMO ETFs, please see the specific risks set out in the BMO ETF’s prospectus. BMO ETFs trade like stocks, fluctuate in market value and may trade at a discount to their net asset value, which may increase the risk of loss. Distributions are not guaranteed and are subject to change and/or elimination. BMO ETFs are managed by BMO Asset Management Inc., which is an investment fund manager and a portfolio manager, and a separate legal entity from Bank of Montreal. BMO Global Asset Management is a brand name under which BMO Asset Management Inc. and BMO Investments Inc. operate. “BMO (M-bar roundel symbol)” is a registered trademark of Bank of Montreal, used under licence.