965. Laura answers a listener's question about how to limit investment losses using buffered ETFs.
965. Laura answers a listener's question about how to limit investment losses using buffered ETFs.
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Welcome back to Finance Friday, another special edition of Money Girl, where I answer your burning money questions! Today's topic comes from Bonnie, who says:
"I know that I should be investing more, but I get really worried that the stock market will have a major crash, and then I'll be sorry. I've heard about an investment called a buffered ETF that limits potential losses. Can you do a podcast that explains buffered ETFs and how to buy them?"
Thanks for your question, Bonnie. I know many investors share your concern about losing money or selling investments at the worst possible time. Buffered ETFs or exchange-traded funds are an excellent option for certain investors. This post will explain how buffered ETFs work, who should consider owning them, and their pros and cons based on your investing goals.
Welcome back to episode 965 of Money Girl–I appreciate you downloading the show! I'm Laura Adams, an award-winning author, on-camera spokesperson, female money speaker, and founder of The Money Stack, a Substack newsletter.
You can learn more, ask any money question, and sign up for the Money Stack at LauraDAdams.com. You can get the newsletter for free or become a paid member with access to my live educational and Q&A events. Additionally, you can ask a money question by leaving a voicemail at 302-364-0308.
What is a buffered ETF?
Buffered ETFs are a relatively new class of exchange-traded funds that launched in 2018 and are gaining popularity. According to Morningstar, there are over 400 different buffered ETF funds, with about $70 billion in assets.
They're also known as defined outcome ETFs because they limit your potential losses and gains. That makes buffered ETFs an excellent choice for someone like Bonnie who wants their money to grow but also wants to limit potential risk.
Investors typically use buffered ETFs as a complement to their portfolios or even as an alternative to bonds for fixed income. But they come in various risk-reward combinations you can customize.
For instance, some buffered ETFs offer more gains when the stock market rises, while others provide investors with more downside protection when markets decline. It's an investment vehicle that allows you to make money when the financial markets rise, but limits your losses when they fall.
Buffered investment strategies aren't new; they've existed for many years in investments like mutual funds, annuities, and other products sold by insurance companies. However, the ETF versions are becoming more well-known and accessible to investors.
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How do buffered ETFs work?
How buffered ETFs work depends on the amount of protection the fund manager plans to offer on the downside, known as the buffer, and the amount of upside they plan to pay on the upside, known as the cap. These goals are achieved by investing in year-long options contracts where the manager buys or sells shares in an ETF at a set price or before a specific date.
In general, the buffer is fixed, such as ranging from 8% to 20%. The greater the downside protection, the smaller your potential gain will typically be.
For example, if you bought the Innovator S&P 500 Buffer ETF (BAPR) last year, you'd have a 9% buffer against losses for a year. The fund tracks the SPDR S&P 500 ETF Trust (SPY). Therefore, if SPY drops up to 9% during a 12-month period, you'd lose nothing. But if it drops 10% by the end of the period, you'd have a 1% loss.
That limited loss is terrific; however, it comes with a cost. For example, the potential 12-month return of BAPR was 18.3%. That means if the SPY had a 20% return, you'd forfeit 1.7%.
Many people are willing to accept limited returns when they understand that their potential losses are also restricted. Buffered ETFs give you some amount of predictability in your portfolio. That makes them similar to a one-year bond that you hold until maturity.
However, there's no penalty for selling a buffered ETF early. You can exit at any time without incurring additional fees.
At the end of a 12-month period for buffered ETFs, the fund rebalances by buying new options. You can automatically roll over your money to the fund's next 12-month period or leave it.
READ ALSO: Am I investing too much for retirement?
What are the pros of buffered ETFs?
The primary benefit of buffered ETFs is that they provide investors with a cushion or buffer against losses. If you're a nervous investor or can't tolerate much volatility because you're nearing or in retirement, downside protection might help you sleep better at night.
With a buffered ETF, you know its cap is the best-case return and its buffer is your worst-case loss. The potential upside can be much better than leaving cash sitting in a CD or high-yield savings account. While deposit accounts have no risk, they pay low returns that typically don't beat inflation, causing your money to lose value over the long run.
Buffered ETFs trade just like a regular ETF on various financial markets. You can buy and sell them using a taxable brokerage account or a tax-advantaged retirement account.
READ ALSO: 8 things to know about investing in a brokerage account
What are the cons of buffered ETFs?
While buffered ETFs have many benefits, no financial product is without its downsides. A primary con is having limited or capped upside potential. When the markets are moving up, you won't get to take advantage of the full amount. If that would frustrate you, then a buffered investment isn't your friend.
Additionally, there's no guarantee against losses, as you can still incur amounts exceeding the buffer. For instance, if the fund loses 20% and you have a 9% buffer, you're still down 11%.
Additionally, buffered ETFs typically have higher fees than a typical actively managed diversified fund because they're more complex to manage. Investment fees always erode potential profits.
Lastly, a buffered ETF's cap and buffer only apply in full if you own it for an entire year. If you buy or sell mid-period, the downside protection and potential return will be different than what's stated for 12 months.
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Who should consider owning buffered ETFs?
The pros and cons of buffered ETFs make them excellent for anyone who wants to limit potential investment losses and gains. In general, this describes investors who are nearing or already in retirement.
For instance, if you retire at 65, you will likely need your investment portfolio to beat inflation and grow moderately for 20, 30, or more years. But a retiree can't afford a major portfolio crash that would derail their standard of living.
We don't know Bonnie's age or retirement time horizon. However, we know she's a
conservative investor who isn't comfortable taking too much risk.
While a buffered ETF doesn't eliminate risk, as you get when buying CDs or keeping money in the bank, it gives you a narrower range of potential outcomes to count on. Knowing you could lose a little, but not a lot, could be the ticket for becoming a more comfortable investor.
However, if you're relatively young or comfortable taking investment risk, then traditional index funds may be better for you. If you have a time horizon of at least 20 years, embracing volatility can really pay off. Accounting for fees, uncapped index funds have historically paid investors an average annual return of 10%.
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Where can you buy buffered ETFs?
Several fund families offer buffered ETFs, including Innovator, First Trust, and BlackRock. Different brokerages, such as Fidelity, ETRADE, and Charles Schwab, sell them. Once you open an account with a brokerage firm, you can purchase any products on its investment menu.
There are also variations on buffered ETFs, such as those that don't cap potential returns but require you to give back a percentage of the potential returns. For example, if you must return 3% and the market climbs 8%, you'd earn 5%. But if it skyrockets to 30%, giving back 3% leaves you with a 27% return.
To sum up, buffered ETFs offer a trade-off between potentially lower returns and smaller losses. They're not for you if you don't need or want to manage risk and want maximum growth. However, if you're willing to forfeit market gains to protect yourself from losses, buffered ETFs are excellent tools to consider.
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