In October 2020, the SEC enacted rule 18f-4, removing regulatory barriers that were preventing exchange traded funds from using derivatives to enhance returns. Asset managers quickly sprang into action, launching a still-expanding catalog of so-called buffer ETFs and related products that incorporate derivatives to generate extra dividend income and/or protect against losses.
Risk-averse investors who don’t want to totally lose out on equity performance have been diving in, in droves. According to data tracker FactSet, these ETFs have attracted more than $31 billion of new money over the past 12 months, bringing their total assets to almost $120 billion.
But what do advisors think of these products? “They can help clients stay invested for the long term without being as concerned with short-term volatility,” said Rob Swanke, senior investment research analyst at Commonwealth Financial Network in Waltham, Mass. “The defined outcomes help give clients a bit more comfort with the level of risk they are taking.”
These ETFs work by holding a basket of securities while simultaneously selling (sometimes called “writing”) call options on those securities to a third party at a predetermined “strike price” that’s above the current price of the assets, advisors explain. The options have an expiration date. If the asset appreciates before that date, the buyer gets a bargain, but if it loses value the option can simply expire. Either way, the option buyer must pay an upfront premium that becomes an extra dividend for the ETF holder no matter what happens to the underlying asset.
Many of these ETFs are buffer funds that cap investor gains in exchange for limiting potential losses. Others are known as “equity premium income” ETFs, which offer a higher degree of upside potential but less or even no downside protection. “Their popularity is really around being able to define the acceptable losses for a portfolio,” said Swanke.
But this kind of “defined outcome” comes at a cost, detractors say. For example, the Calamos S&P 500 Structured Alt Protection ETF, which tracks that broad market benchmark but caps gains at 9.8% while providing 100% downside protection, carries an annual fee of 0.69%, much higher than a passive S&P 500 ETF, though fairly typical of other actively managed ETFs, according to industry watchers.
Similarly, the huge JPMorgan Equity Premium Income ETF, which invests in a basket of large-cap U.S. stocks, returned roughly 10.5% the past 12 months, lagging the S&P 500 by roughly 14 percentage points. But it generated dividends of roughly 8%, charging an annual fee of 0.35%.
“These products are more expensive than traditional fixed income [securities],” acknowledged Swanke, referring to the traditional assets for hedging against market swings. “So you really need to weigh how much of these you need. If clients aren’t very concerned with short-term fluctuations of the market, then there really isn’t a need to spend the extra cost for these products.”
Still, many investors are concerned that markets are too rich right now and due for a correction, he said, especially those in or approaching retirement. A degree of “skittishness” is understandable, he added. Buffer ETFs can be ideal for those who want to protect their assets without entirely missing out on future market gains, if there are any, he said.
Yet other advisors point to additional reasons why these ETFs may be a good fit for some clients. “As my largest clients are foundations with required annual distributions of 5%, buffered ETFs help ensure that these clients can make the 5% without having to eat into the corpus or liquidate securities,” said Michelle Connell, owner and CIO of Portia Capital Management in Dallas. “Buffered ETFs also help individual clients who need income—especially those that are receiving their required minimum distributions from their IRAs.”
She uses two dividend-producing ETFs—the JPMorgan Equity Premium Income ETF and the JPMorgan Nasdaq Equity Premium Income ETF, which uses the Nasdaq 100 as its underlying index. Its average yield is roughly 9%, she said, and both funds charge 0.35% in fees. They are “worth paying for,” she insisted, because they enable her to participate in equity markets while receiving a generous income stream.
Buffer ETFs, however, would not appeal to “aggressive investors that want to participate in market momentum,” she added. “They will be disappointed with their performance if the markets continue to melt up.”
Nevertheless, high expenses and limited upside potential are enough to make some advisors leery. CFP Board Ambassador Charles Weeks Jr., founder of Barrister in Philadelphia, is one of them. ““I choose not to use ETFs with derivatives,” he said. “I don’t find them to be beneficial for clients because of the opportunity cost the buffers create, along with the actual cost of the ETFs themselves.”
ETF sponsors are responding to such criticisms by introducing competitively priced products, advisors observe. But that might not be enough for those who find other products such as bonds a cheaper way to protect against equity volatility.
Indeed, for advisors like Pat Nerney, vice president of investments at Dynasty Financial Partners in St. Petersburg, Fla., the decision of whether or not to allocate client funds to buffer ETFs depends partly on market factors such as interest rates. These are “driving elements that determine the cost of protection and the corresponding cap [on upside gains],” he said.
Meanwhile, he dismisses the view that buffer ETFs are just a passing fad. The strategy of using options to enhance returns is something advisors have been doing on their own with the component parts for quite a while, he said. That’s because, for the right client, it can be rewarding.
“Being able to offer clients market participation with some protection is a great way to get cash from the sidelines to work,” said Nerney.