Investing in the stock market often involves navigating the delicate balance between risk and reward. For many investors, the ideal scenario is to benefit from stock market gains without exposing themselves to potential losses. This concept, while seemingly perfect, has historically been challenging to achieve. However, recent developments in financial products have made this dream more attainable. Specifically, the introduction of 100% buffer exchange-traded funds (ETFs) has created new opportunities for investors seeking to protect themselves from downside risk while still aiming for reasonable returns.
Buffer ETFs and Their Evolution
Buffer ETFs have been around since 2018, designed to offer a degree of protection against market declines. These funds work by using options strategies to hedge against losses while capping the potential upside. Early versions of these ETFs typically protected investors from the first 10% to 20% of losses, but their potential for returns was significantly limited. Essentially, investors had to choose between having limited downside protection with a capped upside or taking on more risk for higher returns.
This scenario has changed dramatically with the advent of newer 100% buffer ETFs. These funds, introduced over the past year by major investment firms like Innovator Capital Management, BlackRock’s iShares, Calamos Investments, and First Trust, offer complete protection against market declines. Investors are shielded from any losses, with the ETF’s downside protection covering 100% of the decline up to a specified buffer level. In return, these funds set a cap on potential gains, which typically ranges between 8% to 11% annually—closely aligning with the long-term historical average returns of stocks.
The Impact of Rising Interest Rates
The viability of these 100% buffer ETFs has been significantly enhanced by recent changes in interest rates. The performance characteristics of these ETFs are heavily influenced by interest rates and the cost of options used to gain exposure to indices such as the S&P 500. When interest rates were near zero, the cost of options was high relative to potential returns, making it difficult for such ETFs to offer attractive terms. The situation has transformed with current yields on Treasury bills—considered the risk-free rate—rising to around 5%. This higher yield reduces the cost of purchasing options, allowing for more favorable terms in buffer ETFs.
The mechanism behind these ETFs involves combining options strategies with cash or Treasury bills. The higher interest rates enable these funds to afford more extensive options exposure, which in turn increases both the upside cap and downside protection. By holding cash or T-bills, investors benefit from the yield on these assets, which helps finance the cost of options that provide exposure to stock indices while ensuring downside protection.
How 100% Buffer ETFs Work
The structure of these 100% buffer ETFs includes periodic resets of their cap rates, typically every six months, one year, or two years, depending on the fund. For instance, the iShares Large Cap Max Buffer June ETF (ticker: MAXJ) offers a one-year “hedge period” from July 1, 2024, to June 30, 2025. This ETF provides a “starting cap” of 10.64% and a “starting buffer” of 99.50%, after accounting for a 0.50% expense ratio. This means investors have a maximum “starting downside before buffer” of -0.50%.
The benefit of investing in these ETFs extends beyond simple protection and capped returns. They offer tax advantages as well. The ETF structure is inherently tax-efficient, often avoiding taxable capital gains or income distributions through complex options strategies. For example, the Innovator Equity Defined Protection ETF—1 Yr July (ZJUL) uses “deep in the money” S&P 500 call options that incorporate T-bills’ yields into the options’ pricing, thus sidestepping direct taxable income from T-bills. Conversely, the iShares ETF holds shares in the iShares Core S&P 500 ETF (IVV), which provides dividend income that is taxable.
Risks and Considerations
While these ETFs present an attractive option for investors seeking to mitigate downside risk while capping their upside, there are notable risks and considerations. One significant risk is the opportunity cost associated with the cap rates. If the S&P 500 exceeds the ETF’s cap rate, investors may miss out on higher returns. Additionally, if an investor buys into an ETF after the S&P 500 has risen above the ETF’s set price for the benchmark, they could face exposure to losses up to the buffer threshold before the protection takes effect.
For instance, as of July 19, the iShares ETF reported a “remaining cap” of 9.44% and a -1.58% “downside before buffer.” This indicates that investors need to be aware of the ETF’s specific buffer statistics and understand how they affect their potential investment outcomes.
Conclusion
The introduction and evolution of 100% buffer ETFs represent a significant advancement in investment strategies, allowing investors to protect against market declines while still aiming for reasonable returns. These funds leverage current interest rates and options pricing dynamics to provide a compelling balance between downside protection and upside potential. As always, investors should carefully consider the specific terms and risks associated with each ETF and stay informed about market conditions that could impact their investment choices.