Buffer exchange-traded funds (ETFs) offer a potential solution to a well-known problem in behavioral finance, which is that many investors find losses to be much more distressing than missing out on potential gains.

Buffer ETFs have become one of the fastest-growing corners of the ETF market. Since 2018, over 250 buffer ETFs have been launched, and they’ve attracted over $47 billion in assets. But it’s important for investors to understand that covering structured products in an ETF “wrapper”—which is what buffer ETFs are, in a nutshell, as we’ll explain below—doesn’t make them any less complex. Investors should be prepared to fully unwrap any investment product they are considering investing in, before making
the investment.

The story starts with structured products

“Structured products” refers to packages of derivative contracts tied to other assets or metrics in the broader financial markets, such as equity indexes, credit spreads, interest rates, commodity prices, etc. Traditionally, structured products have been offered by large investment banks to both retail and institutional investors.

These packages of derivatives offer investors unique patterns of returns in structures (often medium-term
notes or insurance contracts) that are more convenient, and potentially more tax-efficient, than holding derivatives contracts directly.

While they often sound great, structured products historically have come with some significant drawbacks. They can be expensive and often have opaque fee structures. They can be complex and difficult to value. They often contain credit risk, which means that they depend on large investment banks standing behind certain promises, and, in most cases, they lack secondary market liquidity, making them nearly impossible to sell before maturity.

Enter the ETF wrapper

In 2018, fund sponsors began enclosing structured products within the ETF “wrapper,” believing they can
offer the same strategies with greater transparency, more secondary market liquidity, and lower credit risk
than traditional types of structured products. Buffer strategies were the first, and are currently the most
popular, structured product strategy to be offered in an ETF wrapper.

Buffer ETFs are funds that seek to provide investors with the upside of an asset’s returns (generally up to a capped percentage) while also providing downside protection on the first predetermined percentage of losses (for example, on the first 10% or 15%). These ETFs frequently have the term “buffer” in their names, but not always. They may also use the terms “collar,” “risk managed,” “outcome,” or “SOS” (which, in this case, stands for “structure outcome strategies”).

Most of the buffer ETFs currently on the market have a one-year outcome period, meaning that the caps and buffers (as stated) apply only to investors who purchase on the rebalance date and hold the ETF throughout the entire outcome period. Investors who purchase after the rebalance date will receive different caps and buffers based on the performance of the referenced index between the
rebalance date and when they purchased the fund. Fund sponsors usually post the remaining buffers, caps, and days in the outcome period on funds’ websites.

Buffer ETFs are often built with flexible-exchange, or “FLEX,” options. Like other types of options, FLEX options give their buyers the right, but not the obligation, to buy or sell a security at a set price in the future. Like other options, they are guaranteed, or “cleared,” by the U.S. Options Clearing Corporation (OCC), a self-regulatory organization monitored by both the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), and funded through the fees of member exchanges. This should provide FLEX options with lower counterparty risk than private swaps or other types of customized derivative contracts used in traditional structured notes, due to centralized clearing
through the OCC.

Caravel Partners is not a fan of Structured Products, and therefore we view Buffer ETFs with scepticism.