The Latest S&P 500 “Buffer ETF” Comes With 100% Downside Protection

The Latest S&P 500 “Buffer ETF” Comes With 100% Downside Protection
Reda Farran, CFA

7 months ago7 mins

  • Buffer funds offer hedged exposure to stocks by limiting losses while also capping gains. They're a good option for investors who are risk-averse, seeking stability, or nearing retirement.

  • If you’re considering buying into a buffer fund, you’ll want to look at its remaining cap and buffer levels. Also, you’ll want to keep in mind that these funds are expensive and don’t always perfectly track the underlying asset.

  • Innovator Capital’s latest product, which is tied to the S&P 500, offers 100% downside protection while capping gains at 15% after fees. This ETF could make sense if you’re risk-averse but still want to capture some gains if the market keeps rallying.

Buffer funds offer hedged exposure to stocks by limiting losses while also capping gains. They're a good option for investors who are risk-averse, seeking stability, or nearing retirement.

If you’re considering buying into a buffer fund, you’ll want to look at its remaining cap and buffer levels. Also, you’ll want to keep in mind that these funds are expensive and don’t always perfectly track the underlying asset.

Innovator Capital’s latest product, which is tied to the S&P 500, offers 100% downside protection while capping gains at 15% after fees. This ETF could make sense if you’re risk-averse but still want to capture some gains if the market keeps rallying.

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Innovator Capital Management, pioneer of the “buffer ETF”, has just launched a new version that’s the first of its kind: offering 100% downside protection. That sounds pretty amazing, but it does come with a catch. Let’s take a look at how these funds work, so you can decide whether this latest offering is worth your investment dollars.

What’s a buffer fund?

These funds offer hedged exposure to stocks by limiting losses while also capping gains, and they’re not exactly a new concept. Since their inception, they’ve attracted industry giants like BlackRock, and they’ve drawn about $5 billion in inflows so far this year.

But even before they came around, investment banks were offering their clients “structured notes” – a hybrid product that combines bits and pieces of different financial instruments into one to create customized risk-reward profiles. While there are many different types of structured notes out there, “buffer participation notes” are among the most popular. The notes and buffer funds work in the exact same way – they’re just packaged as different investment vehicles.

Having said that, buffer funds are a lot more accessible for retail investors. Buffer participation notes, like most structured notes, are typically offered by investment banks only to sophisticated, high-net-worth clients. Buffer ETFs, by contrast, can be bought and sold just like any ordinary stock.

That’s why, sensing an opportunity, Innovator Capital Management launched the world’s first buffer ETF in 2018 and has since expanded its offerings to include more than 50 of the funds, amassing over $12 billion in assets.

How do buffer funds work exactly?

The performance of a buffer fund, also known as a defined-outcome fund, is tied to an underlying asset – like a stock market ETF. The fund aims to provide a predetermined return profile over a specific period (e.g. one or two years), called the “outcome period”. It also has a preset "buffer" level, or a certain amount of market decline the fund aims to protect against. This could be 10%, 15%, or some other figure, depending on the specific fund. At the end of the outcome period, the value of the buffer fund – and therefore the amount you’ll get – depends on the performance of the underlying asset. Here’s how it works:

  • If the underlying asset falls by an amount within the buffer level, the fund will absorb that loss and be worth what it was at the start of the outcome period. That means, other than the fund’s fees, you’d make no loss on the investment (assuming you bought in at the start).
  • If the underlying asset’s drop surpasses the buffer level, then you’d be taking that negative return, but it’d be offset by the buffer amount, reducing your loss. For instance, if the buffer level is set at 10% and the underlying asset drops 35%, then the fund would only protect against the first 10% of the loss: you’d have to swallow the remaining 25% drop.
  • If the underlying asset goes up, you’d get that positive return, but only up to a specific limit – your return would be capped. So you wouldn’t capture all of the underlying asset’s returns if it does particularly well. It’s a tradeoff, sure, but it’s how the fund can afford to offer downside protection.

Here’s what a buffer ETF’s payoff profile looks like:

An illustrative example of a buffer ETF’s return profile. Source: Innovator Capital Management.
An illustrative example of a buffer ETF’s return profile. Source: Innovator Capital Management.

Should you invest in buffer funds?

Buffer funds might be a good option if you’re a conservative investor and willing to sacrifice some potential returns in exchange for protection against losses. They also might appeal to you if you’re seeking stability during times of market volatility, or if you’re nearing retirement (preserving capital is a top priority when you’re about to start drawing down your investments). What’s more, because buffer ETFs trade like normal stocks, they’re quite liquid and can be bought and sold daily. But, if you’re seriously considering buying into a buffer ETF, there are three important things to consider.

First, they’re not exactly cheap. Innovator Capital Management’s funds tied to the SPDR S&P 500 ETF tend to have an expense ratio of 0.79%. That’s considerably higher than the expense ratio of the underlying ETF, which is 0.09%.

Second, the downside protection and upside cap on a buffer fund are relative to the start of the outcome period. For example, take a buffer fund launched six months ago with an upside cap of 15%. And now imagine that the underlying asset has gone up by 14% during that time. In that scenario, there’s very little incentive to invest in the fund because you’re almost at the cap limit. Put differently, your maximum upside potential is 1%, but you could lose a lot more if the underlying asset starts heading south.

Similarly, take a fund launched six months ago with a buffer level of 20%. And now imagine that the underlying asset has gone down by 19% during that time. There’s also very little incentive to invest in the fund in that scenario because it’s used up most of its buffer. That’s why with products like these, it’s very important to consider the remaining cap and buffer levels, which Innovator Capital Management discloses in real time for all of its funds. Ideally, you want to invest only in funds with substantial remaining cap and buffer amounts relative to the fund’s starting levels. These are highest at the start of the outcome period (or when the price of the underlying asset closely aligns with its value at the start of the outcome period).

Example of a fund’s remaining cap and buffer (before ETF fees / after ETF fees). Source: Innovator Capital Management.
Example of a fund’s remaining cap and buffer (before ETF fees / after ETF fees). Source: Innovator Capital Management.

Third, because a buffer fund is constructed using derivatives (mainly options), it won’t perfectly track the underlying asset when the options are still far from expiration – that is, when there’s still a lot of time left in the outcome period. That means that the fund won’t capture upside immediately if there is a big rally in the underlying asset. Ultimately, to get the exact payoff profile promised by the buffer fund, you have to hold it from the first day of the outcome period until the last day.

What about Innovator Capital Management’s latest buffer ETF offering?

The latest offering, which is tied to the SPDR S&P 500 ETF, basically sets the buffer level at 100%, making it the first ETF to offer full protection against downside moves. In exchange for this bulletproofing, gains are capped at around 15% after fees. The outcome period is set at two years – meaning, investors will realize the predetermined return profile in July 2025.

With complete downside protection, the ETF is aimed at the most conservative investors – those who are holding lots of cash but who are reluctant to deploy it because of concerns about a potential crash. So if you’re risk-averse and fearful, but still want to capture some gains if the market keeps rallying, this ETF might be just the ticket. And with its 100% downside protection, it might be best slotted into your portfolio as an alternative to short-term bonds or cash. If, on the other hand, you think the S&P 500 will be up by more than 15% in two years’ time, then you’re probably better off simply investing in the SPDR S&P 500 ETF (ticker: SPY).

And don’t forget that with interest rates as high as they are, you can get respectable, safe returns in other securities. Two-year US Treasury notes, for example, currently yield 4.9%, which means you could lock in two-thirds of the new ETF’s potential upside over the next two years with what is perceived to be the world’s safest asset class.

You know the saying: there's no such thing as a free lunch in the investment world. You can use buffer ETFs to protect against losses, sure, but you’ll have to forfeit some gains in exchange. Ultimately, it comes down to your risk tolerance and your market views. But now that you know how these novel ETFs work and what to look out for before buying in, you can think of them as another tool at your disposal to help you construct a portfolio that meets your investment goals.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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