In my previous blog posts, I discussed tech sell-offs and market perspectives. To better navigate highly volatile market, I also introduced a highly tax-efficient ETF (BOXX ETF) for conservative investors. On August 3, 2024, I posed an intriguing question: Should you buy the dip during the tech sell-off? Since then, the stock market has recovered rapidly, as I noted in last week's post. Today, I will introduce a relatively new class of ETFs called Buffer ETFs, which provide downside protection.
What? - Understanding Buffer ETFs
Buffer ETFs are designed to offer a layer of protection against market downturns by using options strategies. The concept is simple: investors get exposure to the stock market with a built-in cushion that buffers a certain percentage of losses. However, there is a trade-off; while you gain downside protection, your upside potential is capped.
For example, Parametric Hedged Equity ETF (PHEQ) is a low-cost (0.29% expense ratio) buffer ETF that uses put spread collar for downside protection. In this case, one-year hedges are staggered such that 25% expire quarterly with each hedge offering a 20% downside protection range while maintaining upside return potential. The diagram below illustrates PHEQ's potential return profile (solid blue line) against the underlying equity portfolio's return profile (black dotted line). Please note that all buffer ETFs that provide downside protection come with a cost: lower upside participation.
The chart below shows the performance comparison between PHEQ and SPY (the oldest S&P 500 ETF). PHEQ provided strong protection against the recent downturns (April-May and July-August) but lags behind SPY's strong 1-year return.
So What?
Pros:
Risk Mitigation: Provides downside protection by buffering a certain percentage of losses, which can be appealing during volatile markets. This downside protection can appeal to conservative investors.
Cons:
Trade-Offs in Returns: The protection against losses comes at the cost of a cap on the returns. This could lead to underperformance in a strong bull market compared to traditional ETFs like SPY. This strategy is not suitable for long-term growth-oriented investors.
Complexity: The options strategies underlying Buffer ETFs can be complex, making it harder for some investors to fully understand the product's mechanics and risks.
Now What?
Before deciding to invest in PHEQ or any Buffer ETF, consider your investment timeline, risk tolerance, and market outlook. If you believe that market volatility will persist and you’re nearing a financial goal where capital preservation is key, PHEQ might be a valuable addition to your portfolio. On the other hand, if you're looking to maximize growth, particularly in a long-term bullish market, sticking with SPY or similar ETFs might be the better route.
Buffer ETFs are tools—like any tool, they work best when used for the right job. Evaluate your financial situation and objectives to determine if a Buffer ETF aligns with your needs.
Concluding Remarks
Buffer ETFs, such as PHEQ, offer an intriguing option for those seeking downside protection in their investment strategy. However, the trade-off between protection and potential gains should be carefully considered. For everyday investors, the choice between a Buffer ETF and a traditional ETF like SPY should align with your individual financial goals and risk appetite. A balanced approach that considers both the benefits and limitations of Buffer ETFs can help you make an informed decision that aligns with your long-term financial objectives.
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