Baby boomers who are not ready to step away from the stock market are increasingly turning to a new class of funds that offer both potential returns and protection against losses. These exchange-traded funds (ETFs) utilize derivatives to either generate extra dividend income or guard against downturns, appealing to retirees and other cautious investors who wish to stay in the market without the full exposure to its risks.
These innovative funds, which were almost nonexistent four years ago, now manage nearly $120 billion in assets and have attracted at least $31 billion in new investments over the past year, according to FactSet. This surge in popularity is largely due to their ability to provide stock market returns while also offering some level of protection against market volatility.
The most favored strategy among these funds is known as “equity premium income.” This strategy involves investing in a portfolio of large-cap stocks while selling options contracts on those shares. This approach allows the funds to generate higher dividend income—often between 8% and 10%—but also imposes limits on potential gains and comes with substantial fees.
Another popular strategy involves buffer funds, which use derivatives to protect against investor losses up to a certain point, though they also limit potential gains. Some funds even promise 100% downside protection under specific conditions. These strategies are particularly appealing to baby boomers, who appreciate the combination of stock market participation and protective measures.
Eric Balchunas, a senior ETF analyst at Bloomberg Intelligence, refers to these funds as “boomer candy,” highlighting their appeal to older investors who wish to remain in the stock market while enjoying some level of security that helps them sleep better at night. He notes that a significant portion of the ETF industry is actively working to create more of these types of funds.
Investing heavily in stocks later in life carries inherent risks. Financial advisors caution that a significant market downturn could force retirees to sell their shares at low prices to meet cash needs. Traditionally, the advice has been to shift from stocks to bonds and other safer investments as one approaches retirement. However, many investors abandoned this “100 minus age” rule following the 2008-09 financial crisis, as low interest rates made the stock market one of the few places to achieve substantial returns.
This trend has been driven by a fear of missing out (FOMO). Since the stock market bottomed out in March 2009, the S&P 500 has delivered a total return of over 980%, while the Bloomberg U.S. Aggregate Bond index has returned only 50% over the same period, according to Dow Jones Market Data.
Craig Morningstar, a retired financial advisor from Scottsdale, Arizona, represents a typical investor in this space. At 61, he has allocated 10% of his equity portfolio to buffered and “floored” funds, which offer some protection against market downturns. He believes these funds offer a way to achieve higher returns than bonds over the long term, with less volatility than being fully exposed to the stock market.
One of the funds Morningstar holds is from First Trust, which tracks the Nasdaq-100 and aims to protect against the first 10% of a market slide. If the Nasdaq-100 were to drop 15%, the fund would only fall by about 5%, although it also caps investor gains at around 20%. However, with the Nasdaq-100 up 37% over the past year, investors in buffer funds have missed out on substantial returns. This trade-off highlights one of the drawbacks of derivative-based funds: while they offer protection, they can also limit upside potential during strong market rallies.
There are additional concerns about the effectiveness of these strategies during extreme market stress. During periods when many investors are selling simultaneously and buyers are scarce, prices can drop rapidly. Portfolio insurance, which depends on unlimited liquidity, gained a poor reputation after the Black Monday Crash in 1987.
Another drawback is that most of these funds must be held for the full one-year outcome period to function as intended. Selling early can result in incomplete protection against losses and missing out on potential gains. This is also true for ETFs offering 100% downside protection, designed for extremely risk-averse investors who still want exposure to equities. For example, the Calamos S&P 500 Structured Alt Protection ETF aims to match the S&P 500’s return over a year, with gains capped at 9.8%, while protecting against all capital losses for those who hold it for the entire period. However, it charges a 0.69% annual fee, higher than the fees for passive funds tracking the S&P 500.
The interest in these funds has grown following the Securities and Exchange Commission’s adoption of new rules in late 2020, which made it easier for asset managers to use derivatives in funds. This regulatory change opened up sophisticated strategies to the broader public that were previously accessible only to institutional clients or wealthy individuals.
The JPMorgan Equity Premium Income ETF, launched in 2020, has been particularly successful, quickly becoming the largest actively managed ETF in the U.S. with over $33 billion in assets. Its strategy involves selling options on large-cap stocks, which limits potential gains but generates high dividends—approximately 8% over the past year. The fund charges a 0.35% annual fee.
BlackRock has also responded to the demand for these products, offering eight ETFs that focus on providing downside protection or income through options. Mark Alberici, head of product innovation and development at iShares, BlackRock’s ETF business, notes that these strategies, historically used by institutional and high-net-worth investors, are now becoming popular among a broader range of investors due to their availability in ETF form. BlackRock is even preparing to launch funds with 100% downside protection.
In summary, as automation and AI continue to transform the job market, and as baby boomers seek secure yet lucrative investment opportunities, derivative-based ETFs have emerged as a compelling option. These funds offer a blend of potential returns and protective features, addressing the needs of investors who wish to remain in the stock market while managing risks effectively.