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One of the recent trends in the ETF universe has been the rise of buffer ETFs, otherwise known as defined outcome ETFs.  These buffer ETFs focus on behavioural finance and the fact that many investors find losses to be much more distressing than missing out on potential gains.  They have been flying off the shelves as advisors seek to keep nervous clients exposed to growth assets.

At the last count there are 154 buffer ETFs listed on the US stock markets, with total AUM of $37bn (from less than $200m in 2018, according to Morningstar).  These buffer ETFs have an average expense ratio of 0.81% so whilst on the upper end of ETF pricing certainly cheaper than the products that they were designed to compete against.

Through the use of options, buffer ETFs are able to provide the investor with a pre-defined investment outcome often offering downside protection in a trade off against upside returns.

This graphic from iShares is a great example of how the buffer and the paired upside cap work.  It relates to the iShares Large Cap Deep Buffer ETF (IVVB) which seeks to provide a downside buffer of approximately 5-20% of losses over each calendar quarter.  If the S&P 500 falls more than 5%, the investor will have protection on the downside.  If the S&P 500 moves up, then the returns are capped at 6.23% over each calendar quarter.

If the floor and ceiling structure as described above sounds familiar, and it should, it is because that is the very essence of a structured note.  Structured notes are very popular in times of uncertainty, such as we are currently experiencing, with more than half the world’s population due to head to the polls this year.  Structured notes however have some structural disadvantages, predominantly the illiquidity of the product resulting in the structured note normally held for the full investment term.

This is the reason that buffer ETFs are eating structured notes lunch. The ETF structure creates the secondary market, and so buffer ETFs can be traded live on stock markets.  This liquidity allows for a more flexible investment strategy as through a stockbroking account buffer ETFs can be held alongside other ETFs, shares, bonds and even a selected list of mutual funds.

Selecting the correct buffer ETF can be complicated as one has to look at the live price against the remaining upside cap and downside protection.  Fortunately, we have all the tools to be able to assist you in structuring the necessary protection within your client’s portfolio.   

Magwitch Offshore is a leading provider of Global Balanced ETF portfolios with products in all major currencies. Magwitch utilises an advisor distribution model and their portfolios are available through offshore endowment structures provided by some of the larger Insurers.  Nothing in this Insights can be construed to be financial advice.