After the mania of 2020 and 2021 faded away, many new investors once again had to contend with the prospect of facing unrealized losses and drawdowns in their portfolio. Only this time, bonds did nothing to take the strain off. In fact, the aggressive pace of interest rate hikes actually caused certain bond ETFs with longer durations to suffer losses rivaling or exceeding those of some equity ETFs.
Over in the U.S. market, investor attention quickly turned to a relatively new type of structured product called "buffer" or "defined outcome" ETFs. By employing derivative-based strategies, these ETFs offered investors the ability to target a pre-determined limit for both returns and losses based on the performance of an underlying index.
Canadian investors now have access to these ETFs too. On May 25th 2023, First Trust Canada launched the First Trust Cboe Vest Fund of Buffer ETFs (Canada) ETF (BUFR) on the Cboe Exchange. This ETF employs a "fund of funds" strategy via exposure to various First Trust and Cboe Vest's U.S.-listed "Target (NYSE:TGT) Outcome" ETFs. Let's take a look at the overall buffer strategy and how BUFR itself works.
Understanding buffer ETFs in general
To understand buffer ETFs, it's worth understanding their overall category first: structured products. Unlike your typical ETFs that track only stocks or bonds, structured products are a bit more complex.
You can think of them as pre-packaged investment strategies designed to offer specific risk-return objectives that can't be easily achieved with standard financial instruments. These products often use derivatives and can be tailored to the specific needs or views of the investor to create a specific risk-return profile.
Buffer ETFs are structured products because they combine an investment in an index with a series of options to create a specific risk-return profile. They are designed to limit potential losses (provide a "buffer") while still offering potential upside based on the performance of an underlying index.
While each buffer ETF will employ its own strategy, they all tend to share some similarities, which include:
- Underlying Index: First, it's important to note that each buffer ETF is linked to an underlying index, such as the S&P 500. The overall performance of the ETF is benchmarked to the performance of this index.
- Upside Cap: Buffer ETFs are designed to provide you with the returns of the underlying index up to a certain limit, known as the "cap". For example, if the index increases by 15% over the specified period and the cap is 10%, you will only gain 10%.
- Downside Buffer: On the downside, the ETF offers a "buffer" against a specified degree of losses. This buffer could be up to 10%, 15%, or even 20%, depending on the specific ETF. For example, if the index falls by 20% and you have a 10% buffer, you will lose 10%. If the index falls by less than the buffer amount, you wouldn't lose anything.
- Outcome Period: The buffer and cap apply over a specific period, typically one year, known as the "outcome period". At the end of the period, the buffer and cap reset, and a new outcome period begins.
- Derivative Use: Buffer ETFs achieve this defined outcome structure through the use of derivatives, most commonly in the form of options. These instruments give the ETF the right to buy or sell the index at certain prices, which creates the cap and buffer effect.
BUFR brief overview
As its name suggests, BUFR will be a "Fund of Buffer ETFs". That is, the ETF invests in an equal-weighted portfolio of four First Trust and Cboe Vest Target Outcome ETFs tracking the S&P 500 up to a predetermined cap, while buffering against the first 10% of losses (before fees, expenses and taxes) over a defined one-year "Target Outcome" period.
Currently, BUFR's portfolio consists of:
- First Trust Cboe Vest U.S. Equity Buffer ETF – August
- First Trust Cboe Vest U.S. Equity Buffer ETF – November
- First Trust Cboe Vest U.S. Equity Buffer ETF – February
- First Trust Cboe Vest U.S. Equity Buffer ETF – May
BUFR charges a 0.15% management fee in addition to the weighted management fee of the four underlying ETFs. Right now, the total management fee (BUFR and underlying combined) is capped at 1% annually.
BUFR simple explanation
When an investor buys BUFR, their money is split between four underlying ETFs. Each of these ETFs has a strategy in place to try to meet specific investment goals with defined caps and buffers over a certain period, which resets each year. These four strategies don't all reset at the same time; instead, they reset at different times throughout the year.
Think of it like having four different safety nets, each one set up at a different time. This approach, known as a "laddered" strategy, is designed to spread out risk. The idea is that by having these strategies reset at different times, you're less exposed to bad timing or sudden changes in the market.
However, depending on when BUFR buys into these ETFs, it might miss out on some of the protection offered by these strategies. This is because both the cap and buffer can run out if the market moves too much, too quickly. This is especially true if BUFR doesn't buy into the ETF right at the start of its target outcome period.
When a new target outcome period starts, the upside participation level (the "cap") for that ETF is reset based on current market conditions. This means the cap on returns could be different each time. Because BUFR typically won't buy into an underlying ETF exactly at the start of its new cycle, it might not get the full benefit of the cap.
In other words, even with this "laddered" approach, there's no guarantee that BUFR will fully achieve its targeted investment outcomes. It's important to remember that there's always a degree of risk in investing, especially when it comes to complex derivative-based strategies.
This content was originally published by our partners at the Canadian ETF Marketplace.