Looking for the hottest new investment vehicle? Well, look no further. Buffer ETFs (exchange-traded funds) are currently one of Wall Street’s most popular offerings. Jason Zweig of The Wall Street Journal wrote, “In 2018, there were 13 of these funds managing a total of $3.8 billion, according to Morningstar; at the end of last month, 342 held a combined $108.3 billion.”
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But, for the uninitiated, what are buffer ETFs — and are they a good investment choice?
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Traditional ETFs vs Buffer ETFs
First, here’s what exactly traditional ETFs are: a type of pooled investment security that holds multiple underlying assets, such as stocks and bonds. ETFs are similar to mutual funds, differing primarily in that they can be traded all day, like a stock — as opposed to only after the market closes.
Like most investments, however, ETFs are subject to market fluctuations.
Enter buffer ETFs — also known as defined outcome ETFs — which use options contracts to insure against some losses while capturing some gains. Yet, they aren’t without drawbacks.
GOBankingRates takes a look at the pros and cons of buffer ETFs, so you can adequately weigh the opportunity cost prior to diving in.
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Pro: Increased Protection Against Loss — Con: Capped Returns
The primary caveat with buffer ETFs is that, while they provide downside protection, they also limit an asset’s returns.
“To buy that buffer, or protection against loss,” wrote Zweig, “you relinquish your right to participate fully in the potential gains.”
For example, a buffer fund could hypothetically offer 50% protection against loss with a 7% upside cap. This means that you are shielded from losses if the market drops by up to 50%, but, if the market goes up 20%, you are still only entitled to a 7% return.
Does the Pro Outweigh the Con?
This could be a desirable investment for those entering retirement and not wanting to risk losing money at a time when they won’t be able to earn it back, or for individuals saving up for a down payment on a home and wanting to shield their savings from a potential market drop, while still retaining the possibility of growth.
In other words, if your time horizon is short and your risk profile is low, buffer ETFs could be a great option.
However, as conventional wisdom goes, holding onto the content of one’s portfolio for the long haul typically leads to growth.
“Over all 12-month periods since 1970, the U.S. stock market has gone up 80% of the time, with an average return of 12.3%,” wrote Zweig. By purchasing a fund that caps growth, investors could be leaving large amounts of money on the table.
Plus, “buffer ETF investors typically don’t receive dividends, which have contributed up to 2.2% annual returns to the S&P 500 over the past 20 years,” wrote Kate Dore of CNBC.
Pro: Cheaper, Simpler and Relatively Safer — Con: More Costly and Complicated Than Traditional ETFs
“With annual expenses typically under 1% and no commissions, [buffer] ETFs are much cheaper than fixed annuities or the complex debt instruments called structured notes that Wall Street has peddled relentlessly,” wrote Zweig. “They’re less risky than stocks alone, have no risk of default and are tax efficient.”
Sounds great, right? Well, they could be. But make sure to read the fine print.
Buffer ETFs have what is known as an “outcome period,” where traditional ETFs do not. This means full protections and full gains only apply if investors buy and hold the buffer fund for a set window of time — typically one year.
“You may not get full upside exposure when buying midway through the outcome period,” wrote Dore. “Similarly, selling before the outcome period ends could limit downside protections.”
Additionally, buffer ETFs have slightly higher fees than traditional ETFs: 0.8% for the average buffer ETF compared to 0.51% for the average traditional ETF.
Takeaway
Buffer ETFs can be a fantastic investment for those looking to sleep better at night knowing they aren’t going to lose their entire life savings in a market crash. However, buffer ETFs do not net the most money over the long term.
As with most financial decisions, take a look at your personal goals, risk profile and time horizon before pulling the trigger — and, of course, always review the terms and conditions.
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This article originally appeared on GOBankingRates.com: Should You Invest In Buffer ETFs? 2 Pros and Cons You Should Know
