In recent years a new investment vehicle called buffer ETFs has become more popular among investors. Buffer ETFs provide investors with stock market exposure while offering downside protection, trading off potential gains to mitigate losses. These ETFs, such as BlackRock's new iShares Large Cap Max Buffer Jun ETF (MAXJ), cap the upside but offer 100% protection against losses within a specified "outcome period." For instance, MAXJ caps gains at 10.6% for the period from July 1, 2024, to June 30, 2025, while also ensuring investors avoid losses if the S&P 500 declines within that timeframe.
It's crucial for investors to compare buffer ETFs with other low-risk investment options like CDs and Treasuries, which currently offer around a 5% return. Choosing a buffer ETF like MAXJ makes sense only if investors are willing to forego the guaranteed 5% return from these safer investments in hopes of achieving a higher return of up to 10.6% if the market performs well over the next year. However, the risk lies in the possibility of the market declining. In such a case, the investor would end up with only their initial investment minus fees, rather than securing the guaranteed 5% return from CDs or Treasuries.
An additional, less obvious risk lies in the missed upside potential. If the stock market continues its bull run and rises more than 10.6% over the next year, investors in buffer ETFs won't benefit from any gains beyond that cap. This trade-off means they could miss out on significant additional returns that they might have captured with a different investment strategy.
In recent years, Buffer ETFs have grown in popularity, particularly among risk-averse investors and those nearing retirement who want market exposure without the risks associated with bear markets. Since their inception in 2018, the market has seen a significant increase in offerings, with 283 buffer ETFs available and $48.8 billion invested as of July 2023. Adam Shell, Investors Business Daily author recently reported on the trend of buffer ETFs and wrote, “The top two issuers are First Trust and Innovator. This year alone, defined-outcome ETFs have taken in $7.1 billion in new investments, a 17% rise.” These funds are growing in popularity because they use an options trading strategy to provide downside protection.
They are tailored to different risk tolerances, ranging from conservative to aggressive, making them suitable for many investors. They also help investors stay invested during volatile markets which can be particularly appealing during times of economic uncertainty. Despite their benefits, buffer ETFs come with higher fees and may not be suitable for younger investors focused on long-term growth. It’s critical to purchase them near the start of a new outcome period and hold them to maturity to achieve the defined outcomes. While buffer ETFs reduce equity declines and can serve as an alternative to cash or bonds, investors must be comfortable with the trade-off of capped gains.
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