In October 2020, the Securities and Exchange Commission enacted rule 18f-4, removing regulatory barriers 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 use derivatives to generate extra dividend income 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,” says 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 third-party buyer gets it for a bargain, but if it loses value the option can simply expire. Either way, the option buyer must pay an up-front 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 use options to 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,” Swanke says.
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%. That’s much higher than the fee for a passive S&P 500 ETF, though it’s fairly typical for actively managed ETFs, industry watchers say.
The JPMorgan Equity Premium Income ETF, which invests in a basket of large-cap U.S. stocks, returned roughly 10.5% over the past 12 months as of early July. It lagged the S&P 500 by roughly 14 percentage points, but it generated dividends of roughly 8%. Its annual fee is 0.35%.
Swanke acknowledges these products are expensive. “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 says, especially those investors who are in or approaching retirement. That can make buffer funds more attractive. They can also be ideal for investors wanting to protect their assets without entirely missing out on future market gains, he says.
There are other reasons these ETFs may be a good fit for some clients. Michelle Connell, the owner and CIO of Portia Capital Management in Dallas, says her largest clients are foundations that must distribute 5% per year. “Buffered ETFs help ensure that these clients can make the 5% without having to eat into the corpus or liquidate securities,” Connell says. “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. Both funds charge 0.35% in fees. She says the equity market participation and the income stream together make the funds worth paying for.
Buffer ETFs might not appeal to “aggressive investors that want to participate in market momentum,” she adds. “They will be disappointed with their performance if the markets continue to melt up.”
The high expenses of these funds and their limited upside are enough to make some advisors leery. One of them is Charles Weeks Jr., the founder of Barrister in Philadelphia (and a CFP Board ambassador). “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,” he says.
ETF sponsors are responding to such criticisms by introducing competitively priced products. But that might not be enough for those who prefer other cheaper products to fight equity volatility, namely bonds.
Pat Nerney, vice president of investments at Dynasty Financial Partners in St. Petersburg, Fla., says interest rates will matter to those considering buffer ETFs. These are “driving elements that determine the cost of protection and the corresponding cap [on upside gains],” he says.
Still, he dismisses the view that buffer ETFs are just a passing fad, adding that advisors have been using options to enhance returns for quite a while, and for the right client they 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,” he says.