Buffered ETFs - a solution looking for a problem?
- Noel Watson
- 2 days ago
- 7 min read
Updated: 1 day ago
Introduction
Buffered ETFs are often marketed as a way to protect investors from the extremes of stock market downturns. For example, if a particular stock market or index falls 25% over a year, a buffered ETF that protects the investor from the first 15% of a market decline should, in theory, end the year around 10% down.
Advocates of this approach suggest these products can protect retirees from:
Sequencing risk: We have written extensively about sequencing risk, and while we believe it's rarely an issue for those with diversified portfolios, it's worth keeping an open mind to evaluate products that can help mitigate potential issues.
Loss aversion is a cognitive bias in which individuals perceive the pain of loss as more significant than the pleasure of an equivalent gain. A product that can limit overall portfolio drawdowns, thereby helping investors avoid capitulating and selling their investments, can be beneficial.
Buffered ETFs debuted in 2018 and, following the market volatility of 2020 and 2022, have become increasingly popular for U.S.-focused investors.
Recent history
Buffered ETFs are often based on the S&P 500 index. For our analysis, we will select a buffered ETF that protects investors from 15% of the downside. How has it performed over the past few years?
2020
If we look at 2020 first, we can observe that the maximum drawdown (the amount the portfolio falls from peak to trough) was around 20% for the S&P 500 (red line) and 10% for the buffered ETF (blue line). We might expect the buffered ETF to fall only 5%, given it protects the first 15% of market falls, but this 15% is measured at the end of a certain period, in this case, a year, so the product has the potential to fall more than expected (vs the index) during the period.
2022
For the twelve months ending in 2022, the S&P 500 fell 18.2%, and the buffered ETF by 3.75%. This gap of 14.45% is slightly less than the 15% advertised (the expected fall should be 18.2%-15%=3.2%).
This could be down to two things:
The buffered ETF is based on the price return index, which excludes dividend income.
The downside protection number (e.g. 15%) is sometimes quoted before fees and expenses. For our example, the fees are 0.8%.
Is the S&P 500 a valid benchmark?
Quant firm AQR recently published a paper titled Rebuffed: A Closer Look at Options-Based Strategies. In this, they suggested a more appropriate benchmark should be used.
For our analysis, we will diversify the S&P 500 by adding 50% cash.
2020
We can now see that the outcomes are now almost identical, with the 50% S&P 500/50% cash having a slightly lower drawdown (-9.7% vs -10%) and a slightly higher final balance (around 0.85% higher).
Things look more positive for the buffered ETF in 2022, when both bonds and equities suffered, more so for U.S.-based investors than for those in the UK. The latter was fortunate to benefit from a rapidly depreciating pound, which limited the downside for the equity part of a globally diversified portfolio. The maximum drawdown for the 50/50 portfolio is around 3% worse (-11.55% vs -8.5%) than for the buffered ETF and ends the year more than 4% lower.
2022
Whole period
The buffered ETF we are examining was launched in late 2019. If we compare the portfolios over this period, we see that the buffered ETF has provided a lower return with higher volatility but also a lower maximum drawdown.
This comparison does not provide any conclusive evidence that the buffered ETF we are examining offers a clear benefit over an S&P 500 index fund diversified with cash. AQR had the following to say:
To be blunt, these “buffered funds” are a marketing success, a success for the managers selling them, and a failure for investors lured in by the overpromise of magical equity returns without equity risk and then overcharged for the pleasure.
It's worth noting that we had the benefit of hindsight when deciding what to add to our S&P 500 holding to reduce the downside. Holding a longer-duration bond fund would have shown the buffered ETF in a far more favourable light.
2000-2010 lost decade
Setting the benchmark
The last two bouts of market turbulence have been beneficial for some markets of "innovative" financial products. Bonds didn't provide the protection some investors expected in 2022, and the COVID downturn was brief enough to put some products (such as smoothed funds) in a favourable light.
We recently covered the relative pain of market turbulence dating back to the early 1990s and also why basing your retirement plan solely on the S&P 500 has the potential to deliver suboptimal retirement outcomes.
To evaluate how buffered ETFs perform during periods of prolonged market stress and whether they can mitigate sequencing risk, we will examine the 2000-2010 "lost decade."
We will start with the following portfolios to set some benchmarks:
Portfolio 1: 100% S&P 500 (as examined above)
Portfolio 2: 50% S&P 500, 50% cash (as examined above)
Portfolio 3: A globally diversified 60/40 portfolio containing a mix of passive and factor funds.
The starting portfolio balance is $1,000,000, and we will draw an inflation-adjusted $50,000 (5%) per year.
At the end of the decade, we can see that Portfolio 1 (blue line) has really suffered, with a final balance of just under $300,000. Portfolio 2 (red line) has performed slightly better, with a balance of around $520,000, while Portfolio 3 (yellow) finishes just north of $1,100,000.
How did the Buffered ETF fare?
We will now attempt to model the buffered ETF. If we first analyse without the annual withdrawals (starting at $50,000), the S&P 500 was down around 9% (£908,832) over the decade. However, this includes reinvested dividends. If we strip these out (recall buffered ETFs are based on a price-only index), the falls are around 24% (£758,831).
For our buffered ETF, we will make the following assumptions:
The maximum upside at the end of each year is capped at 12% (gross). As a Morningstar article points out, in investing, there is rarely a free lunch, and the price you pay for some downside protection comes at the cost of limited upside.
The downside buffer is 15% (as for the product above).
Fees are 0.8%, and these will be taken annually from the gross return.
There are several things to observe.
The range of returns has been reduced from 28.68% and -37% to 11.2% and -24.29%.
The 12% cap is triggered three times (yellow), and in the worst case (2003), gives away over 15% of the gains (26.38% vs 11.2%).
In both 2002 and 2008, the buffered ETF reduces annual losses by 14.2% (red).
In 2000 and 2001, the portfolio fell by only 0.8% (green) net of fees, as the unbuffered portfolio fell by less than 15%.
The final balance of $473,921 is somewhere between the S&P 500 $294,311 and the S&P 500/cash mix at $517,133.
How has the recent retiree fared
We will finally examine how a retiree finishing work in late 2019 (when our example buffered ETF was launched) fared.
Portfolio 1: Buffered ETF
Portfolio 2: S&P 500
Portfolio 3: A globally diversified 60/40 portfolio (as above)
The S&P 500 portfolio (red line) has offered by far the best outcome, with a final balance of over $1.5 million. When you compare it to the lost decade above, where the S&P 500 investor's balance was down by around half after the same period, you can see how favourable the last few years have been and that sequencing risk has not been an issue - if anything it's the complete opposite!
Both the buffered ETF ($1.12 million) and the 60/40 portfolio ($1.04 million) ended the period in positive territory.
Conclusion
It's worth mentioning first that our analysis is by no means comprehensive and contains many simplifications. However, this is often unavoidable when attempting to analyse products that have been in existence for a very short time period and is one of the reasons they do not feature in our client portfolios, where we typically analyse a century of historical market data.
Based on our analysis, when comparing our example buffered ETF, an investor gives away over half of the potential maximum upside while accepting more than half of the downside. While a buffered ETF approach may offer a better outcome compared to a 100% S&P 500 portfolio during periods like the 2000-2010 lost decade, we'd suggest that a globally diversified portfolio is a better starting point. In our example, it had a final balance of over twice the size of the buffered ETF portfolio at the end of the decade.
Furthermore, as we've discussed in other blog posts, sequencing risk, in our opinion, is often overused. Based on the returns of the S&P 500 over the last few years, it's hard to see what problem the buffered ETF needs to solve.
Finally, when you compare how the diversified portfolio has fared over both periods, with both ending with a balance higher than the starting balance, we struggle to see why you would overlook this as a starting point.
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The team at Pyrford Financial Planning are highly qualified Independent Financial Advisers based in Weybridge, Surrey. We specialise in retirement planning and provide financial advice on pensions, investments, and inheritance tax.
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