Basics of Buffered ETFs

Buffered ETFs are sometimes looked at for helping against losses or downsides in an investor portfolio. The topic of buffered ETFs can be complex and there are several pros and cons to consider. Ron Delegge, the founder of ETFguide, joins Cassidy Clement to discuss.

Summary – Cents of Security Podcasts Ep. 87

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Cassidy Clement:

Welcome Back to the Cents of Security Podcast. I’m Cassidy Clement, Senior Manager of SEO and Content here at Interactive Brokers, and today I’m your host for the podcast.

Our guest is Ron DeLegge, founder of ETFguide. Buffered ETFs are sometimes looked at for helping people against losses or downsides in their investor portfolio, but this topic of buffered ETFs, it can be very complex and there are several pros and cons to consider. In this episode, we’re looking to explore all those details and more. Welcome back to the program Ron.

Ron DeLegge:

Oh, thank you so much, Cassidy. It’s great to be here and great to see you again.

Cassidy Clement:

Yeah. So with this topic, we’ve kind of touched on it here and there, maybe in our IBKR Podcast, which is for more of an advanced trading group, but also in some of our other ETF type of conversations or sometimes if it’s adjacent to it. what exactly are buffered ETFs and how do they get their start in the ETF industry?

Ron DeLegge:

Yeah, well, buffered ETFs are structured products and, they basically have several names. You know, sometimes are called defined outcome buffer ETFs. But, the main point is here is that they have defined or specific outcomes on performance of the underlying index or benchmark, and the whole idea is to basically mitigate risks of potential downturns in financial markets. And then as far as when these products first got their start here in the U. S., the first series of buffered ETFs were introduced in, the summer of 2018 by a company called Innovator. And since then, there’s been other companies that have, you know, ETF firms that have come into the marketplace. We see firms from, PGIM to Allianz, as well as First Trust and Innovator. Those are really the big players in the U. S. ETF marketplace as far as buffered ETFs are concerned.

Cassidy Clement:

Yeah, you hear a lot about buffered ETFs, when people start to feel a little bit shaky in the market, but where exactly can someone trade buffered ETFs? Since it’s kind of a mix of a product.

Ron DeLegge:

Yeah, buffered ETFs can be bought and sold with a normal brokerage account just like any other ETF or stock. So you know, that could be on ,obviously Interactive Brokers has access, you know, these are exchange listed products. So they’ll be on a major exchange like the New York Stock Exchange or Nasdaq, or the CBOE. And so, they have ticker symbols that, can be easily found and then you can buy and sell them. They’re not really what I would call trading tools, they’re more, I would say, strategic portfolio tools. Not so much trading tools. That’s the way I kind of view them. So they are a little bit different in that regard.

You wouldn’t buy, for example a, you know, buffered ETF for like a one month or two month trade. Typically, you know, the reset period is usually one year. Now they’re coming out with different iterations which are sometimes shorter than that. But, many of the first iteration of buffered ETFs, you know, they basically reset every year, once a year and they’re doing that by month, so January, February, March, April. So, you know, they’ve got them lined up, you know, depending on where you’re at in terms of your own investment planning. Like right now, for example, we’re almost into well, we’re going to almost be into February, so you know, all of the buffered ETFs that reset in February, and that’ll be as of February 1st. And so an investor that maybe wants to have a one year outcome, you know, should be eyeing those February, you know, buffered ETFs. So anyway, sorry, to answer, or get so long winded on that, that particular answer.

Cassidy Clement:

No, it’s all good. That kind of leads me into my next question, which is like as there’s these resets involved, or we’ll say like the actual indication of what the buffer is going to be, are there certain benefits or risks or maybe like pros and cons you could say that are associated with these buffered ETFs specifically? Or does it range from what exactly the ETF is centered around?

Ron DeLegge:

Yeah. So pros and cons, you know, let’s start with the cons, right? First of all, you know, there’s limited upside with these particular products, so they’re going to cap the upside and that’ll vary. Now, generally speaking, the larger the buffer, just think about buffer in terms of like insurance, right?

So a buffer, depending on the product, typically, you’ll see buffers anywhere from 10 to 15 some are up to 30% buffers. That means that’s that protection on the downside. So if the index goes down, let’s say 10% percent and you have a 10% buffer, you’re protected, you know, theoretically up to that 10% buffer.

If it goes down 15%, then you’re still only protected 10%. So you have 5% of potential risk that you’re absorbing so that that’s what a buffer means at the high level. And so in exchange for that, you know, the company is going to have what’s called a limited upside or a cap. So generally speaking, the bigger the buffer, the larger your insurance, right? The bigger the protection, the, more limited you are on the upside, right? And that makes sense, that makes sense. That’s the way it works in life, right? The less risk you take, the less reward there is and so it’s the same way with these buffered ETFs. The other thing I would say that could be conceived as a con, right, limited upside. You’re not getting 100% of the performance. You’re also not taking 100% of the risk. The other thing is these products are relatively new. I mean, 2018 was when the first buffered ETFs, here in the U. S. made their debut. And so you think about that, Cassidy, what have financial markets been like since 2018 up until now?

We haven’t had really a full market cycle of crashes and, you know, crises and all kinds of crazy stuff that we’ve seen over longer periods. We haven’t really seen buffered ETFs go through, for example, something like we went through in 2008 and 2009, that financial collapse, so to speak. Now we’ve have had crashes like the Covid crash, market bounced back pretty quick. So that is another potential con, right, the limited performance history, especially during markets that are, you know, have sustained periods of downturn.

The other con might be higher fees, right? Which, you know, again, people that complain about that or say, you know, that’s a negative, of course buffered ETFs have higher fees you big dummy, they’re not like other ETFs. They’re doing something completely different. They’re not going to be like a regular index ETF from Vanguard, you know, and thus they’re going to charge higher fees.

So let’s not, you know let’s not play games and, you know, nitpick, well they have higher fees. Of course they have higher fees because it’s a different product. It’s doing something completely different than a plain vanilla index fund or index ETF. So obviously it’s going to have higher fees. And you know, to that I would also say to these folks that are so cost conscious, you know, the question that I love asking is, what does it cost you if you don’t do it? So that’s the question investors need to really be asking, is it worth the additional cost of the fee to have that peace of mind, to have that insurance policy, so to speak.

This is what these products offer. I didn’t even mention the pros. So, you know, I’ll let you talk.

Cassidy Clement:

No, I mean, you’re highlighting exactly what can be the questionnaire almost to ask yourself a little bit about how you’re going to view this as an investment for yourself. But I mean, there are some pros to this. There’s a certain level of not protection, but not to overuse the word, but buffer to some of these losses. And then you also have the ability to have, you know, some exposure like most ETFs to things that you wouldn’t normally have exposure to. I mean, I don’t know if you want to expand any further on these specifically because they have elements of a traditional ETF as well.

Ron DeLegge:

Yeah, yeah, for sure. Like you’re going to see them tracking in many instances, you know, some of the familiar indexes that most of our listening audience is familiar with, right, S&P 500, Nasdaq 100, and other indexes. You’re starting to see, a bond indexes be introduced. There’s also international equity indexes, so you can customize what your exposures are, just like with any ETF and all you’re doing is choosing what level of protected growth that you want. That’s how I think about these products in the sense of protected growth. And I know anytime you say protected, like from a securities regulation perspective, they start getting nervous.

They’re like, oh, are you making guarantees? Well, that’s the other thing about these products is they come with a prospectus, right? And so they have a stated goal, like any investment product. Now, whether they achieve that goal or not are two separate conversations. And so these are not, even though they do have, you know, that element of protection, they are not FDIC insured products, right?

They can fail in that goal. And so that’s what, you know, I was getting back to my original point of the limited performance history because as an insurance guy, as a risk management guy, and that’s how I was raised. You know, I was raised by an insurance guy, right? My whole family, they’re all in the insurance business. You know, my dad was a successful insurance broker and so, you know, he taught me about the 99 things that could go wrong, not the one thing that could go right. And so, you know, from an investment perspective, you have to keep that in mind you know, these products as great as they sound, and they have, for the most part, you know, succeeded in the sense that they, we haven’t had any major blowups or failures, like during COVID when the market was sinking.

We didn’t have any scandals surrounding these products, for the most part, the ETF firms that we’re running these products executed successfully. Now again, there’s always that risk in the future if we have a sustained downturn or if things get really nuts in financial markets, which we know that can happen and it actually will happen. In fact, if there’s one guarantee we want that I could give you, we will see craziness in financial markets at some point in the future. That’s almost a given, right? Because it’s always happened in the past and it will always happen in the future. That’s just the way financial markets work. And so if we get that sort of craziness, the question is, will these buffered ETFs deliver?

Will they be able to really successfully execute their prospectus mandates and will they be able to give the protection that, investors in these types of products seek? So again, you do get that opportunity for some protected growth. Up until now, they have worked, pretty well and I think, you know, for those investors that are maybe a little bit queasy about financial markets, you know, trading near all time highs. That’s where we’re at right now. You know, we’ve had two great years back to back for these mega cap stocks, which have led the market, you know, and some investors are thinking, well, you know, should I go to cash?

Here’s an alternative, here’s a way to stay invested without that question of do I shift to cash and just sell out everything and wait for the market to drop, this is sort of a bridge for those types of investors and advisors that may be saying, well, you know, I don’t want to get completely out of the market, but, you know, I’d like to still have something. I don’t want to miss potential upside but at the same time, we can’t afford to go backwards. And so that’s, I think where these products have a really good fit and especially for retirees. People that are nearing retirement already in retirement, these are extremely valuable tools that can help them stay invested, but also, you know, not suffer major setbacks or be able to control how much of a setback they’re willing to take.

You know, if they’re not willing to take a very big setback, well then you need to have a ETF with a larger buffer. They’ve got for example, ETFs with a 100% percent buffer. You know, those are sort of new and so again, you’re, you’re limiting and constraining the upside to the maximum with 100% buffer. You’re not getting a very generous upside. So I don’t know that for me, that that would necessarily appeal for me. But I guess some investors it might, but again, it’s up to each investor, each advisor to choose what level of buffer or insurance that they’re willing to take or get or that they want. And then how much upside and exchange what the cap is on that. And the caps will vary too. There’s no, you know, each provider’s different. You know, you’ll have to check the provider websites because these things are constantly changing on a daily basis. But again, it’s very transparent and, you know, investors that want to have that protected growth, or limit the amount of downside, this is definitely an option for them.

Cassidy Clement:

You mentioned the use, if you will, of the product or maybe the experience that it has had on the market because it’s relatively new. With that, sometimes that’s an additional level of complexity for the client because they may need to do an additional amount of research on this because it’s not got historical data to review for any type of trend analysis or understanding of these cycles. Also, you have to look at your cost of fees for other products if that’s what you’re willing to trade off to come over to this product. And then of course, the opportunity cost, which is a really good point, which is if this is something that you’re actually considering and it looks like you’re between that and some other security, what is the opportunity cost of not going with this and going with another security? So with all of these complex questions, it does sound like it’s a complicated security right now. So is it for more of an advanced trader or can really anybody get into it? You just need to be really on top of your investments for this. Is it kind of passive? You know, where can you learn more about it and get an understanding as well?

Ron DeLegge:

Yeah, well, I think it is a little bit more, education involved, you know, versus just a plain vanilla index ETF or even an actively managed conventional long only type of ETF. So it is different in that regard. My thing is, is I think conceptually it’s easy to understand these products. Let’s not over complicate it, I think sometimes these, these product can be over complicated. The complication is how the product is managed on the backend, but that’s not really what clients see. You know, there’s derivatives that these firms are using on the back end and it’s, that’s the complexity conceptually on the front end what clients and advisors see.

I think that’s easy to understand and I don’t think that’s complicated at all. I think what’s complicated is losing money. If you lose 30 or 40% of your portfolio in a declining market, that’s nasty and We know markets can decline quick. You know, there’s an old saying, right? The stocks, take the stairs up, but the elevator down. And so, you know, a retiree that’s lost, you know, 20, 30, 40% of their portfolio in a very short period when it’s taken them, you know, years to build that portfolio’s value, and then they’ve lost it in a very short time. That’s complicated. That will mess up your life. Especially if you’re relying on retirement income from that portfolio, that’s complicated.

And so buffered ETFs by comparison, you know, if they can solve some of that problem, take off that risk. I don’t think that’s complicated at all. That’s just my perspective on it. But yeah, there’s gonna definitely be education. There’s a lot of more choices. I think that’s maybe where the complication comes in, Cassidy, is just the amount of choices, right? And so having a curated experience, right, that education can help you to kind of understand. Which ETFs may fit your situation, which buffered funds may fit your situation, and which maybe, you know, are the ones that you should let go or not look at. So I think that’s where the complication is.

There’s just so many choices and, for folks like me, I know when I go into the store and I get all these choices, especially shoes, shoes are my weakness. I have way too many shoes. And when I go into, any shoe department or anything with shoes and there’s so many wonderful choices, and I just get choice anxiety and I end up not buying anything, you know? So I think it could be the same here with these buffered ETFs, there’s a lot of choices. So I think again, the investor needs to understand themselves. The advisor, working with a client that is maybe looking at buffered ETFs needs to understand the client.

 I mean, if it’s a client that’s really on edge about financial markets and just really queasy, I mean, if the market goes down 1 or 2% in a single day and they’re calling you, then they’re probably a good candidate for buffered ETFs. Now, to what degree of insurance or buffer should they have? Should it be 10, 15, 20, 30% or 100%? That’s going to have to be determined at the individual level, and again. the folks that are less tolerant to risk and less tolerant to volatility, they’re going to naturally gravitate towards buffered ETFs with a higher level of protection versus those that could say, you know, I’m okay with the volatility.

I’m okay with a little bit of risk. I’ll go with a smaller buffer of maybe 10%. So that’s just a general guideline.

Cassidy Clement:

Totally. I mean, you brought up a really good point about the, the choice element, which can be a little bit of an overload for sure, depending on your understanding of your own financial portfolios or if you’ve established financial goals or not. And there’s also this mindset with buffered ETFs, I at least saw it a lot in my research, which is it’s trying to answer the question of playing offense and defense at the same time with one security and sometimes that’s hard to conceptualize. As you said, the actual complexity is behind the curtain, the front end, you’re kind of able to see the up, down and percentage of buffer, but when it actually comes to incorporating these into your portfolios, there’s a lot of questions to ask.

So I’m in turn going to ask you the question, what are some things that you know, listeners should keep in mind if they’re going to look to incorporate buffered ETFs into their portfolio or their financial strategy?

Ron DeLegge:

Yeah, well, you gotta first of all, have a philosophy you know, a framework. And so where would this fit into an overall portfolio? Well, my framework for constructing investment portfolios, I don’t build or manage portfolios like I used to as a registered investment advisor in my former life. I left that role in 2007 but I am still, you know, very interested and connected in how investment portfolios, you know, are built. And the way I look at it is there’s three parts of an investment portfolio. There’s your core and then there’s your satellite. Typically, institutional investors have used this for, decades.

The core is typically, you know, broadly diversified exposure to major asset classes. When I think about major asset classes, I think about five major asset classes, stocks, bonds, commodities, real estate and cash. For the core portfolio, those are the five, what I call five biggies. That’s your core, your non core or satellite supplements that core, so it’s doing things that are different than the core. So it could be more concentrated, it could be more tactical in nature. It can own concentrated securities, which include individual stocks, perhaps leveraged ETFs, going long, going short, single stock ETFs, you name it.

Anything that’s non-core, cryptocurrencies that would fit into the satellite portion or non-core. And then your last piece, and this is where the buffered ETFs do have some application is what I call your margin of safety. Thank you Ben Graham. We’ve heard that before. Margin of safety. He applied it to how an investor picks individual stocks, right? Security selection. So if you pick that company and you buy it at the right price, it would create a buffer.

Oh, we’ve heard that word before, buffer. Or it would create a margin of safety for the investor. Well, guess what? The margin of safety concept does not just exclusively apply to how an investor selects individual securities. It applies to how they manage the entire portfolio makes total sense. It’s not just how we pick stuff, how we risk manage the entire portfolio.

So carve that out, that margin of safety bucket is completely different than your core. It’s completely different than your non core. How is it different? Because in the margin of safety bucket, that’s the only place within the overall portfolio reserved for principle protection strategies. In other words assets or things where you cannot lose any, anything. We can’t risk, you want principle protection. Yeah, you want some upside growth, but that’s not the focus, the real focus of that margin of safety bucket is safety, is protecting principle in all climates. It’s not the sort of thing that’s determined by you know, it’s not like a tactical thing.

It’s not like, okay, well markets are wonderful now, so I should have a, smaller margin of safety or a bigger margin of safety if things get bad. You think about it in this term or this way like insurance. If somebody’s buying insurance on a house, they’re not going to say, you know what, it’s sunny outside today and I don’t see a cloud in the sky. I think I’ll have less insurance today. And then all of a sudden it starts hailing and storming and like it looks like their house is going to fall down. And they say, well, you know, it’s pretty nasty out there I think I should have a bigger insurance policy than I have right now. See, margin of safety, that bucket in the DeLegge framework, the way I look at portfolio construction, it doesn’t work that way.

It’s determined by the investors risk tolerance, how much risk they as an investor can handle. Right. And so that’s, that’s a personal question. You know, should Cassidy’s margin of safety, should it be 10%? Should it be 20%? Well, you’re going to have to determine that on your own. Generally speaking, just a guideline, as a younger investor you can have a smaller margin of safety because you have more time to recover as you age and get older right? And you start relying on this portfolio to generate retirement income and you’re living on it, well then you need a larger margin of safety. You need more protection because you cannot afford to have a massive cut to your retirement income because all of a sudden markets got angry and now you’re down for, you know, 20, 30, 40% in value.

So that’s just a general guideline. But again, getting back to that question, those three buckets: core, non-core satellite, margin of safety bucket, you could fit those buffered ETFs into that margin of safety bucket. And I would say it would be ETFs that offer 100% protection, the partial protection funds, the ones that offer 10, 15, 30%, I would put that in the non-core or satellite portfolio because you’re not getting 100% protection. To me, margin of safety that bucket has to be reserved for assets that your 100% protection and no downside. Again, it’s important to note that if you do use 100% buffer ETF in that margin of safety bucket, just be forewarned that there’s still no guarantee that ETF will protect you 100%. Because remember, the prospectus at the very bottom says you know, 100 percent risk, no FDIC protection, even though it says 100% protection, you know, theoretically, that may not happen. So that’s, that’s the one caveat I would say, that investors need to be aware of.

Cassidy Clement:

Those are some really interesting points. I like the way you kind of explain some portfolio structuring with the core satellite and margin of safety. I kind of thought of it as like, you kind of have the castle, the drawbridge, the wall, you know? Different things that are protecting the core investment which is a really good way to, you know, visually think about what you need to grow, where, how, and how much protection you’re going to need. Because the bigger the castle, the higher the wall. So that’s kind of the way to think about that. But you know, you always bring up great points on our ETF podcast. Thanks for joining us today, Ron.

Ron DeLegge:

Cassidy, thanks for having me and hopefully look forward to seeing you soon again.

Cassidy Clement:

Yeah, of course. So, as always, listeners can learn more about an array of financial topics for free at interactivebrokers.com/campus. Feel free to leave us a rating review on your favorite podcast network. Thanks for listening, everyone.