HOW BUFFERED ETFs WORK

UP AND DOWN

Historically, the stock market has trended upward. Obviously, however, that trajectory has not been a straight line up, but has been instead a series of ups and downs of varying degrees. Taking advantage of market growth is important for your portfolio, but what do you do about major declines?

Siegel’s Paradox states that an investor loses 50% of $100, then gaining back that same fraction, 50%, on $50 would only get me to $75. I need to gain 100% of my new $50 value to get back to even.

It’s apparent that a large drop in the market can be destructive to a portfolio and a financial plan. How can we mitigate the impact of devasting declines? One way is through buffered ETFs. (Note: This is not a recommendation and is for educational purposes only.)

Figure 1: This chart from HaloInvesting.com shows the returns needed to break even with and without buffers.

WHAT ARE BUFFERED ETFS?

Buffered ETFs (exchange-traded funds) are types of securities that seek to protect against a predetermined level of decline in the market. For a hypothetical example, let’s say a buffered ETF seeks to protect the first 15% of losses in the market. Should the market decline by 15% or less, the ETF (at maturity) would be down 0%. So, what if the market is down 17%? Then the ETF would be down 2%. Recovering from a 2% loss is much easier than recovering from a 17% loss. (Please see disclosures for more details.)

There are various buffered ETFs available. For example, some products are at risk for the first 5% of losses but are then hedged to protect from the next 30%. That means if the market is down 35% on the year, this ETF would be down 5%*.

Of course, there is a cost to having such protection. Buffered ETFs will apply a ceiling on potential gains that varies from product to product. If the ceiling is 8%, then when the market is up 5%, the ETF would be up 5%. If the market is up 15%, the ETF would be up the 8% cap limit. The extent of the ceilings often generally correspond with the extent of the downside protection.

The built-in buffers and ceilings of an ETF are based on holding the ETF for a full fiscal year. Buffered ETFs have maturity dates, and each year they reset with a new buffer level and ceiling. If the product was issued in August, the ceiling and floor will reset the following August. The market price of the security throughout the year will track closely but not exactly with the underlying value of the ETF until it reaches maturity. However, you don’t need to hold onto the product for its full duration. Like other ETFs, buffered ETFs are tradable securities on the market and can be sold (or bought) before reaching maturity. In some cases, selling an issued buffer ETF before its maturity can be more advantageous than holding onto it for its entire duration.

MORE THAN JUST BUY-HOLD

If the ETF is working as designed, why wouldn’t you hold onto it for the full timeframe (12 months)?

Let’s say a hypothetical ETF is issued in April with a 12% ceiling and a 15% buffer (the first 15% of losses from the start date are protected). If the market is up 11% by August, the ETF has already come very close to maxing out its potential gains. Even if the market continues to rise, it will be capped at 12%.

But if the market goes down, keep in mind that the protection doesn’t kick in until the original purchase level is realized. In other words, the buffer only kicks in once the market drops below the base value, covering the 15% after that. That leaves a lot of time between August’s value and the ETF’s reset in April, during which the market can pivot in the opposite direction or continue rising well beyond the ceiling. In other words, the downside has expanded to include the unrealized gains of the ETF yet remains capped to the upside. It is in these instances that we think it makes sense to actively trade these ETFs. As mentioned before, buffered ETFs trade on the open market just like other ETFs.

With the new product, if the market continues to rise, you can now take greater advantage of it than if you had remained so close to the cap. If, however, the market drops, you have already locked in your gains and you have a new buffer.

The opposite situation is true as well. Suppose our hypothetical April ETF has a 15% buffer, and by August the market has dropped 14%. If the market drops more than 1% more, it will no longer be protected against the losses. If the ETF is sold, a new position can be purchased that offers a new buffer (and a new cap). Selling the ETF at a loss can also create a tax asset, which can be used to offset any gains in the portfolio.

ONE PART OF A STRATEGY

Like any investment product or strategy, buffered ETFs may not be an appropriate investment for everyone. However, for some, these securities can be a compelling and useful gear in the machine of their financial plan.

If you have any questions or would like more information, please feel free to reach out to us.

Sincerely,

Natalie Brown, CFP®
Director of Client Services
Day Hagan Private Wealth

—Written 11.12.2020.

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Note: This is not a recommendation and is for educational purposes only.

Disclosure: The data and analysis contained herein are provided “as is” and without warranty of any kind, either express or implied. Day Hagan Private Wealth (DHPW), any of its affiliates or employees, or any third-party data provider, shall not have any liability for any loss sustained by anyone who has relied on the information contained in any Day Hagan Private Wealth literature or marketing materials. All opinions expressed herein are subject to change without notice, and you should always obtain current information and perform due diligence before investing. DHPW accounts that DHPW or its affiliated companies manage, or their respective shareholders, directors, officers and/or employees, may have long or short positions in the securities discussed herein and may purchase or sell such securities without notice. The securities mentioned in this document may not be eligible for sale in some states or countries, nor be suitable for all types of investors; their value and income they produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors.

Investment advisory services offered through Donald L. Hagan, LLC, a SEC registered investment advisory firm. Accounts held at Raymond James and Associates, Inc. (member FINRA, SIPC) and Charles Schwab & Co., Inc. (member FINRA, SIPC). Day Hagan Asset Management and Day Hagan Private Wealth are both dbas of Donald L. Hagan, LLC.  None of the entities listed here in this disclosure are affiliated.

Investing involves risk. Principal loss is possible.

The Cap for each Fund will be set at the beginning of the Outcome Period, and is dependent upon market conditions at that time. Periods of high market volatility could result in higher caps, and lower volatility could result in lower caps.

The funds face numerous market trading risks, including active markets risk, authorized participation concentration risk, buffered loss risk, cap change risk, capped upside return risk, correlation risk, liquidity risk, management risk, market maker risk, market risk, non-diversification risk, operation risk, options risk, trading issues risk, upside participation risk and valuation risk.

Investors purchasing shares after an outcome period has begun may experience very different results than funds’ investment objective. Initial outcome periods are approximately 1 year beginning on the funds’ inception date. Following the initial outcome period, each subsequent outcome period will begin on the first day of the month the fund was incepted. After the conclusion of an outcome period, another will begin.

Fund shareholders are subject to an upside return cap (the “Cap”) that represents the maximum percentage return an investor can achieve from an investment in the funds for the Outcome Period, before fees and expenses. If the Outcome Period has begun and the Fund has increased in value to a level near to the Cap, an investor purchasing at that price has little or no ability to achieve gains but remains vulnerable to downside risks. Additionally, the Cap may rise or fall from one Outcome Period to the next. The Cap, and the Fund’s position relative to it, should be considered before investing in the Fund.

The Funds only seek to provide shareholders that hold shares for the entire Outcome Period with their respective buffer level against Index losses during the Outcome Period. You will bear all Index losses exceeding 9, 15 or 30%. Depending upon market conditions at the time of purchase, a shareholder that purchases shares after the Outcome Period has begun may also lose their entire investment. For instance, if the Outcome Period has begun and the Fund has decreased in value beyond the pre-determined buffer, an investor purchasing shares at that price may not benefit from the buffer. Similarly, if the Outcome Period has begun and the Fund has increased in value, an investor purchasing shares at that price may not benefit from the buffer until the Fund's value has decreased to its value at the commencement of the Outcome Period.