Options Strategies in ETFs, Part 3: Buffer ETFs

How buffer ETFs work

When it comes to understanding buffer ETFs, the intricacies can be quite detailed, given the nature of the strategy and the underlying mechanisms.

While the specific workings can vary across different ETFs, for the purpose of this discussion, let’s delve into the NYSE-listed AllianzIM U.S. Large Cap Buffer20 Nov ETF (NVBW) as a representative example.

At its core, a buffer is a protective layer designed to absorb a specific percentage of losses over a designated period, commonly referred to as the "outcome period." Think of it as a financial cushion that shields an investor's portfolio from initial market downturns over a specific time frame.

For instance, the 20% buffer for NVBW means that the fund aims to protect against the first 20% of losses. Only after this buffer is surpassed would the investor start to see losses in their invested capital.

In practical terms, the mechanism behind this strategy is multi-pronged using FLEX Options, which are uniquely versatile due to their customizable nature, allowing for tailored protection and outcome parameters.

1. Selling Call Options: By doing this, the ETF generates income, but it also establishes an "upside cap," determining the maximum gain the ETF can realize within the outcome period.
2. Buying Put Options: This move is taken to create the buffer, ensuring protection against initial losses.
3. Selling Put Options: This step helps fund the purchased put, but it also means that after the buffer limit is exhausted, any further market downturns will see the ETF's value decrease commensurately.

Buffer ETFs like NVBW specify three main parameters: the buffer level, the upside cap level, and the outcome period. It's vital for investors to understand that the protective outcomes are reset periodically and can vary based on when they purchase.

• The fund aims to shield investors from the first 20% loss. If the underlying ETF falls by 30%, the Buffer ETF would decline by just about 10%, negating the first 20% of losses. If the underlying ETF only falls by 20% or less, losses are negated. 
• However, if the fund's value has already dipped by 20% or more during an outcome period and an investor buys in at that point, they wouldn't benefit from the buffer as it has been exhausted.
• The fund has a cap on returns. For the current outcome period, the maximum return before fees is 16.90% and 16.16% after expense ratios. Again, this can be reduced depending on when investors buy in.

In the case of NVBW, as of October 24, 2023, investors who purchase the ETF will have a cap of 6.91%/6.89% before/after its expense ratio respectively, and a remaining buffer of 18.25%/18.23% respectively. The current outcome period ends on October 31, 2023 and will reset after.

Benefits and risks of buffer ETFs

A significant advantage of buffer ETFs is the provision of a defined risk-return profile. In an environment where many traditional hedges, such as fixed income, can be unpredictable and heavily reliant on historical correlations holding true, the specificity of a buffer ETF is refreshingly clear.

Buffer ETFs also enable investors to remain engaged in the market, even during uncertain times. The concept behind buffer ETFs is not about exiting the market but modifying the extent to which one participates in its ups and downs. This customization offers an appealing blend of security and opportunity.

Furthermore, when it comes to the mathematics of investing, reducing drawdowns has a tangible advantage. Here's a simple way to think about it: A 50% loss in an investment requires a 100% return to break even.

As losses deepen, the percentage return needed to recoup them intensifies exponentially. Thus, by curbing the extent of potential losses, buffer ETFs can play a pivotal role in safeguarding portfolios. However, like all investment tools, buffer ETFs are not without their drawbacks.

For one, these funds typically limit the investor's upside potential due to the sale of call options, which are utilized to fund the buffer. While this cap provides a clear picture of the maximum gains, it also means missing out on potentially higher returns in strong bull markets.

The intricacy of buffer ETFs also introduces a level of manager-specific risk. The execution of the intended strategy isn't always guaranteed, and it hinges on the aptitude and diligence of the team managing the ETF.

Moreover, investors ought to be cognizant of the associated costs. With expense ratios often exceeding 0.75%, buffer ETFs can be more expensive than traditional ETFs. This higher fee, in the long run, can eat into the returns, especially when compounded over many years.

Lastly, timing remains a crucial aspect to consider when investing in buffer ETFs. If an investor steps in midway through an outcome period, the remaining cap and buffer might differ from the initial offering.

It's a potential pitfall, but fortunately, most ETF providers offer a variety of buffer ETFs with staggered outcome periods, allowing for flexibility in terms of entry points.

Buffer ETFs in portfolio construction

When it comes to integrating buffer ETFs both advisors and retail investors have a new avenue to explore. Instead of leaning on conventional strategies such as low-beta or minimum variance approaches, they can opt for buffer ETFs.

By doing so, they're directly implementing tools designed to offer protection from specific downside risks while still allowing for upside participation. This becomes especially valuable in a market environment characterized by uncertainty or heightened volatility.

Additionally, for those portfolios that are heavily laden with bonds, buffer ETFs present an interesting proposition. As interest rates fluctuate, bond prices can be adversely affected. In such scenarios, an over-reliance on bonds can introduce notable interest rate risk.

Buffer ETFs, in contrast, can offer a level of protection from equity market downturns without exposing the investor to the vagaries of the bond market.

The strength of buffer ETFs lies in their specificity. For instance, consider an investor who has explicitly voiced concerns about potential market downturns.

If they're keen on ensuring their portfolio doesn't suffer a 20% loss over the forthcoming year, the task becomes relatively straightforward with buffer ETFs.

Advisors can identify and allocate to a buffer ETF tailored to provide protection against this exact magnitude of drawdown. This level of customization is challenging to achieve with traditional diversification methods.

The key takeaway

Buffer ETFs offer a unique approach to investing, providing a layer of protection during market downturns. These ETFs are great tools for investors looking to manage risk, especially in volatile markets. They set clear boundaries for potential losses and gains, giving investors more predictability.

However, buffer ETFs are just one aspect of the broader options landscape in ETFs. Stay tuned for our final piece, where we'll explore more advanced and niche options strategies within ETFs.

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.