Analysts speak out against $51B 'buffermania' ETF boom

They’re a tempting proposition for anyone getting worried about the bull market’s longevity: exchange-traded funds that keep you from losing money — should stocks suddenly go south.

Buyers have flocked to the products, known as defined outcome or buffer ETFs, plowing in $2.7 billion of fresh money this year through Wednesday, to bring total assets to a record $51 billion, Morningstar Inc. data show. The ETFs — which typically also put a ceiling on how much you make when shares rise — use options to cover losses down to a preset threshold, often 10% or 15%.

Now, a cohort of analysts are out with research saying the trades are too fancy for their own good. 

One argument goes that these funds have delivered subpar returns over the long haul, in markets whose direction of travel is usually up. As hedges, another critique goes, you’re often better off just keeping some money in cash.

“Buffer funds are often marketed as low-risk, alternative, or diversifying strategies. However, given their high correlation to equities, this characterization is misleading,” said Nicolas Rabener, founder of financial analytics firm Finominal who calls the boom Buffermania. “These products don’t create much value.”

Since 1980, a typical fund of this kind has foregone profits more often than it benefited from the limit on losses, a study by Leuthold Group showed. The analysis by Finominal found the ETFs tend to move in tandem with the S&P 500 and their efficiency as hedges is dubious.

Criticism relying on hindsight following a long stretch in which stocks gained is beside the point, say two of the strategy’s advocates — Vest Financial LLC and Innovator Capital Management LLC. The funds’ workings are clear to anyone buying them and make sense for investors looking for insurance and a modicum of predictability, they say.

It’s a mistake to consider the funds as stock replacements, says Graham Day, Innovator’s chief investment officer. Rather, they’re an alternative for retirees who worry that bonds may tumble in unison with equities — as happened in 2022 — and those seeking juicier returns than cash-like investments. 

“We have a lot of advisers have been using this as a way to diversify away from bonds, get cash off the sidelines,” Day said. 

Scrutiny is picking up around the popular and complex products, once reserved for institutional investors and which are now packaged as low-cost, easy-to-trade vehicles for the masses. While details vary by fund, the general mechanism requires the selling of a bullish call to fund the purchase of a bearish put or a put spread. That way, an investor is allowed to keep the gains up to the point of the call’s strike price, while avoiding some losses under the shield of the put.

Loss-limiting tactics were helpful at the height of recent market turbulence. During the 2022 bear market, the Cboe S&P 500 Buffer Protect Index, a benchmark, lost roughly 8%, compared with a 19% slump in the underlying equity measure. 

But anyone sticking to the trade had to live with much smaller gains in the following two years when stocks rallied back. The missed profits over the stretch amounted to 16 percentage points. 

That, in a nutshell, is the rebuttal from Scott Opsal, director of research & equities at Leuthold. While acknowledging the value of buffer funds for highly risk-averse investors, he warned the lost upside can be “quite significant.” 

Opsal developed a S&P 500-linked portfolio with a 14% cap and a 15% floor — a range that he says is typical of buffers nowadays. Among all the 12-month periods since 1980, the S&P 500 exceeded the model’s cap 42% of the time, more than double the frequency when stocks sold off and the loss-limiting benefit started to kick in. 

“The true cost of capped upside is driven home in sustained market advances,” Opsal said. “And the last two years were an excellent test case for understanding the impact of truncating prospective gains.” 

While a desire to hedge is legitimate, it’s debatable whether the buffer trade is worth what you pay for it, according to Rabener at Finominal. The average expense ratio for buffer ETFs is 0.8%, compared with 0.1% for the largest tracking the S&P 500.

The former hedge fund manager picked the Vest US Large Cap 10% Buffer Strategies Fund (BUIGX), one of the oldest offerings in the space, as a proxy in a case study. After comparing its performance to a portfolio that blends the S&P 500 and cash, he found the fund has delivered similar returns but higher volatility and a bigger maximum drawdown since its 2016 inception. 

Such underperformance hasn’t stopped investors from piling in. Over the past five years, assets in the ETFs have surged 23-fold. 

The appeal lies in the relative certainty in returns, something that can rarely be achieved by investing in bonds or low-volatility stocks, according to Karan Sood, chief executive officer and founder of Vest. 

“Let’s say you wanted to make that investment for one year on a pool of money that you did not want to jeopardize,” he said. “You can rest easy. This thing is not banking on historical correlations to hold up in the future. It’s telling you, it provides protection within the buffer.”