Buffered ETFs Compared: Which Option Offers the Best Protection?

Exchange-traded funds, or ETFs, are a special investment fund that pools some assets that may or may not be from a single asset class. ETFs can thus be traded on the market like any other asset. Each ETF can be designed to serve a purpose. For example, the S&P 500 ETF was designed to track the 500 leading publicly traded companies in the U.S. ETFs can track a diverse collection of asset classes or the price of a single commodity against another commodity; the possibilities are endless. These ETFs allow traders to invest in multiple asset classes and companies simultaneously while ensuring the process is streamlined and simple. 

Like any other investment in the trading world, ETFs can also incur losses. This is why traders use various risk mitigation techniques for ETs, too. These techniques work exactly like they would for conventional market trades. These mitigation strategies may include putting a stop-loss order, position sizing, avoiding leverage wherever possible, adjusting trades according to the latest developments, and following a strategy. Each trader has their own way of navigating the stock market, and with time, they develop a strategy that works best for them and is according to their finance goals. 

There are many different types of ETFs; one such type that provides a sort of risk mitigation is a buffered ETF. A buffered ETF is also known as a buffer ETF or, most commonly, a defined outcome ETF. When traders invest in a defined outcome ETF, their losses and profit are capped. This means that if they incur a loss under a certain level, the ETF will absorb it, and likewise if the profit goes above a certain level, the ETF will again absorb it. So, as the name suggests, buffer ETFs provide a buffer against market loss while capping profits. Investing in such ETFs requires technical information and understanding from the trader if they want to make a profit.

Many different investment firms offer buffer ETFs as a way of trading. Each ETF offers a certain percentage of buffer against loss and profits. This percentage is agreed upon before placing the order and can be 5%, 10%, 15%, or more, depending upon the firm and the trader. Until now, this ETF trading option seems excellent for making profits while mitigating your potential risks, but there are some downsides attached to it. As buffer ETFs provide a buffer against loss, they also cap your profit, which means if the profit on your trade goes beyond a certain pre-agreed percentage, the surplus profit will go to the ETF. Secondly, the traders still incur losses even if there is a buffer. Thirdly, the buffer is set in place for a certain amount of time, so if your loss is capped, it will only be capped for a certain amount of time, after which you will be exposed to the full potential of the trade. 

Despite these downsides, buffered ETFs are very famous among risk-averse and conservative investors. For beginner traders, if you want to get into the buffered ETFs space, we recommend first collecting knowledge on the subject and practising on a demo account. This will help you understand the trade in detail and also help you devise a technique that is best suited to your financial goals. In this article, we will take you through everything you need to know about buffered ETFs, their benefits, comparisons with other ETFs, and much more. 

How Do Buffered ETFs Work?

Buffered ETFs define a set of instructions, including the capping percentages for loss and profit. Another essential metric to define here is time. Most ETFs run for a minimum of 12 months but some ETFs may also reset quarterly or bi-yearly. Generally, buffered ETFs do not buy the stocks but use options such as financial contracts. Firms can provide a buffer in the trades by using these financial contracts. For example, Imagine you are investing in a 10% buffered ETF on NASDAQ. If the index falls 8%, the investor incurs no loss and the ETF absorbs it. If the index falls 12%, the trader incurs a 2% loss because the first 10% is buffered. 

As explained, an ETF is generally structured and given a timeframe of 12 months. For maximum cap and benefit, traders must enter the trade at the start. However, they can also enter at any time during the year but may not enjoy the full perks of the buffered ETF. Likewise, if the traders decide to sell their positions before the agreed time, they may not receive the anticipated profit. Quite a few minute technicalities go into a buffered ETF trade, and it is up to the trader and the firm on what they agree upon. 

Benefits of Investing in Buffered ETFs

We know that a buffered ETF provides a cap on loss and profit and is one of the market’s most famous ETF trading instruments. The following are the benefits of investing in buffered ETFs:

Partial Downside Protection

The first benefit of buffered ETFs is surely its ability to protect against losses. This means that if an ETF’s loss goes beyond a certain limit, the ETF will absorb it, and the trader will have to face no loss. It is important here to remember that this protection or capping of losses is based on the agreed-upon percentages, and also, this partial downside protection is only provided within a certain period of time. 

Lower Portfolio Volatility

The buffer ETF provides a buffer in the trade, meaning the trader can anticipate the loss and profit. This means that the overall portfolio stays in a low volatility phase, which can be very beneficial for the traders and help match their trading strategy. Additionally, because there is a cap on loss and profits, traders do not mind keeping a position in the most volatile times in the market.

Opportunity for Potential Upside

Even with a buffer in place and a cap on losses, traders still have the potential to earn big. The details of a potential upside and trader’s take will depend on the ETF and the assets pooled under it, the firm conducting the ETF, the trading strategy, and the agreed-upon technicalities of the trade. 

Likewise, buffered ETFs also have a few drawbacks, which include capped profits, partial downside protection, additional fees, no dividend payments, and a restricted defined outcome period. 

Comparing Buffered ETFs to Traditional ETFs

Exchange-traded funds, or ETFs, are a special type of investment fund that pools several assets that may or may not be from a single asset class. They can be traded exactly like a single stock on the market. Buffered ETFs, on the other hand, provide a buffer and cap the losses and profits in a trade. Buffered ETFs come with a built-in risk mitigation technique, whereas in traditional ETF trading, traders need to place these techniques manually. However, buffered ETFs only offer a percentage of loss absorption for a specific period of time. 

Here is a table that compares essential aspects of traditional and buffered ETFs:

Buffered ETFs vs. Fixed Index Annuities vs. Structured Notes

Buffered ETFs offer a capped loss and profit arrangement for traders, making it an attractive avenue to pursue. Additionally, a few other financial instruments offer fixed or capped profit or loss statements over a certain period of time. These include fixed index annuities, which provide guaranteed income but with some restrictions, and structured notes, which offer customised risk-return trade-offs but, again, with some restrictions. Here, we explain the key differences and similarities between Buffered ETFs vs. Fixed Index Annuities vs. Structured Notes. 

Market Conditions and Buffered ETFs

Buffered ETFs balance loss and profit while working in the market. The performance of each buffered ETF is affected by the conditions of the markets, so traders experience varying performances in different market conditions. Here we look at such performances in different markets:

Bull Markets

In a bull market, buffered ETF holders cannot experience the full excitement when prices are increasing. This is because, like their losses, their profits are also capped, and any additional profit than the agreed-upon threshold will be absorbed by the ETF. 

Bear Markets

In a bear market, prices decrease steadily or abruptly, but traders are capped at a certain loss percentage, which means they only experience a loss when it goes beyond their decided threshold. 

Sideway Markets 

In sideways or smooth markets, traders can expect the anticipated loss and profit as written in their trades. 

Risks and Considerations of Buffered ETFs

As with any investment instrument, buffered ETFs have some risks and considerations that the traders should know about. Here are the risks and considerations of buffered ETFs:

Possibility of Significant Losses

After the cap percentage is reached, traders will experience any losses that incur. This means that “buffered ETFs guarantee zero loss” is untrue. For example, as explained earlier, you are investing in a 10% buffered ETF on NASDAQ. If the index falls 8%, the investor incurs no loss, and the ETF absorbs it. If the index falls 12%, the trader incurs a 2% loss because the first 10% is buffered. 

Liquidity Constraints

Buffered ETFs have time constraints, which means traders who buy or sell before the pre-arranged time may incur losses or not achieve their original trading goals. Unlike buffered ETFs, traditional ETFs offer no liquidity constraints. 

Complexities of Buffered ETFs

Buffered ETFs are an attractive avenue to pursue because of their capped losses, but the technicalities and information involved in setting up such trades are complex and should not be taken lightly. 

Conclusion: Should You Invest in Buffered ETFs?

In conclusion, a buffered ETF, also known as buffer ETF or most commonly known as a defined outcome ETF, is a financial instrument where a trader invests in a defined outcome ETF, and their loss and profit are capped. This means that if they incur a loss under a certain level, the ETF will absorb it, and likewise if the profit goes above a certain level, the ETF will again absorb it. So, as the name suggests, buffer ETFs provide a buffer against market loss while capping profits. Investing in such ETFs requires technical information and understanding from the trader if they want to make a profit. Investing in buffered ETFs is a good idea for experienced traders who enjoy risk-averse trading and have a more profound knowledge of the markets and the ETFs-conducting firms. 

For beginner traders, we suggest that they first experience traditional trading and learn its ways thoroughly. Buffered ETFs have a lot to offer, but they are complex landscapes that may not be easy for beginner traders to navigate. However, the last decision is yours, and we hope you step into the world of buffered ETFs with your due diligence and understanding. 

Additional Resources and References

The buffered ETFs space is very vast and requires a deeper understanding of the process and the associated technicalities. We recommend that you gain information from a few different resources to build your expertise in the matter. Additionally, buffered ETFs is not a singular topic and touches different aspects of the trading world like options trading, traditional ETFs trading, risk mitigation techniques, buffered ETFs trading platforms, and much more. There are also a number of different platforms that offer this type of trading and have their own ETFs and associated regulations. Therefore, do your due research before entering the complex yet exciting world of buffered ETFs.