The beginning of 2022 saw a rare financial event: bonds and stocks both dropped simultaneously, leaving Canadian investors looking for better ways to protect their assets in bear markets. Cash-like ETFs, which currently yield over 5%, have been an option.
However, the question of market timing looms large: when should investors switch to cash and how much of their portfolio should be allocated to this asset class? The decision-making process of toggling between risk-on and risk-off modes can often leave investors perplexed.
This is where buffer ETFs, or defined-outcome ETFs, come into play. These financial instruments promise investors the best of both worlds: the opportunity to remain invested in the market while also enjoying the comfort of a certain degree of downside protection.
Recognizing the potential, BMO (TSX:BMO) Global Asset Management, a top ETF issuer in Canada, recently launched three such products: the BMO Canadian Banks Accelerator ETF (ZEBA), BMO US Equity Accelerator ETF Hedged to CAD ETF (ZUEA), and the BMO US Equity Buffer ETF – October Hedged to CAD ETF (ZOCT), all on Cboe Canada.
It's worth noting that these aren't typical index ETFs, as they're actually classified as “alternative mutual funds” under National Instrument 81-102. Let's explore how these new ETFs work.
BMO Canadian Banks Accelerator ETF (ZEBA)
ZEBA aims to give its holders two main benefits: income and a return that's double the positive performance of the BMO Equal Weight Banks Index ETF (ZEB), but only up to a certain limit (this is what we call "a cap").
However, if the index has negative performance, ZEBA holders could see their investment value go down, but only at the same rate as the index (single exposure).
In simpler terms, if the bank index goes up, ZEBA tries to give you twice that growth, but only up to a certain point. If the bank index falls, ZEBA will decrease in value at the same rate as the index.
This ETF isn't a one-time deal. It's designed to be held for a long time. Every quarter (or every three months), its goals and settings "reset." That means, roughly every three months, it starts its game plan of aiming for double growth and protection against falls all over again.
The very first time it aims to do this is from its launch date until the end of 2023. After that, each new three-month period starts from January 2024 and keeps going like that indefinitely.
BMO US Equity Accelerator ETF Hedged to CAD ETF (ZUEA)
Like ZEBA, ZUEA aims to offer its investors two main advantages: regular income and a return that is double the positive growth of its underlying asset. However, instead of tracking Canadian banks, ZUEA references U.S. stocks via the BMO S&P 500 Hedged to CAD Index ETF (ZUE).
However, this double growth target has a limit, which is referred to as "a cap". That being said, if the S&P 500 index has a downturn, then ZUEA's value would also drop, but only at the same rate as the index itself. Like ZEBA, your upside is capped, but your downside isn’t magnified two times.
Put simply, if the S&P 500 index rises, ZUEA aims to offer you twice that growth up to a certain point. If the S&P 500 index drops, ZUEA's value will decrease at the same pace as the index.
Just like ZEBA, ZUEA is made to be held for a prolonged period. Every three months (quarterly), its goals "reset". This means that about every three months, it begins its strategy of aiming for double growth and protection against declines all over again.
The first time it aims to achieve this is from when it's first available until the end of 2023. After that, every new three-month goal starts from January 2024 and continues in that pattern.
Notably, like its foundational ETF (ZUE), ZUEA is "currency hedged". This means it tries to lessen the impact of Canadian dollar (CAD) fluctuations against the U.S. dollar.
In practical terms, if the CAD strengthens (or appreciates) against the U.S. dollar, currency hedging can help prevent losses for Canadian investors. Conversely, if the CAD weakens (or depreciates), the hedging strategy might limit the potential gains that could have been realized from the currency's movement.
BMO US Equity Buffer ETF – October Hedged to CAD ETF (ZOCT)
ZOCT has a slightly different goal from the previously mentioned ETFs. Instead of trying to get the most profit when the market is doing well while keeping the downside risk unleveraged, ZOCT focuses more on managing the risks when things don't go as planned.
Firstly, ZOCT aims to provide its investors with both a regular income and a growth rate that mirrors that of ZUE, which I'll refer to as the "Reference ETF" for simplicity. However, this growth is bound by a limit known as "a cap".
Essentially, there's a set maximum return ZOCT aims to provide over a given period, regardless of how much the Reference ETF might grow beyond that cap. But the upside isn't just capped for no reason – it's used to finance ZOCT's protective "buffer" feature.
This means that if the market takes a downturn and the value of the Reference ETF decreases, ZOCT offers a safety cushion against the initial 15% of that drop.
Put simply, if the Reference ETF starts to lose value, ZOCT shields investors and doesn't begin to lose its value immediately. The drop in ZOCT's value kicks in only after the Reference ETF has declined by 15%.
This protection and potential growth offered by ZOCT is not perpetual but is structured around a set timeframe known as the "Target (NYSE:TGT) Outcome Period". This is essentially a yearly strategy that begins each October and wraps up around the end of September the subsequent year.
For instance, ZOCT's inaugural strategy aims to work from its launch date till about September 30, 2024. After this, a new cycle commences every October.
In essence, ZOCT caters to investors who are keen on safeguarding their investments rather than maximizing returns. It's designed to offer a balance of growth while providing a buffer against certain market setbacks.
This content was originally published by our partners at the Canadian ETF Marketplace.