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This ‘buffer’ strategy for stock market investors has been a winner

MarketWatch logo MarketWatch 7/12/2021 Philip van Doorn
a group of people riding on the back of a motorcycle © AFP via Getty Images

You may have heard of funds that provide investors with “buffered” exposure to the stock market, but they are not all the same. There are varied degrees of downside protection and upside potential.

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Mike Loukas, CEO of Rosemont, Illinois-based TrueMark Investments, explained the strategy for his firm’s series of buffered ETFs that started to be sold in July 2020 amid roiling markets during the pandemic.

Dealing with volatility

Here’s a chart showing price action for the S&P 500 Index between the end of 2019 and the end of the first quarter of 2020:

That’s a 20% drop for the quarter. However, from a peak intraday level of 3393.52 on Feb. 19, 2020, to the trough of 2191.86 on March 23, 2020, the S&P 500 tanked 35%.

Did you sleep well during that period? Did you have any idea how extensive the federal government’s stimulus efforts would turn out to be?

Another important question is whether you remained invested through the decline and subsequent bounce-back and the gains since then. Here’s a chart showing the S&P 500’s performance from the end of 2019 but through the close on July 7, 2021:

In that period the S&P 500 rose 35%. Not bad for a year and a half. Hindsight is 20/20. Did you remain invested through the decline in February and March 2020? If not, when did you jump back in? There is a natural tendency for market-timers to be late when jumping on the recovery bandwagon.

The case for buffering

What if you could have limited your downside exposure during the pandemic crash, while also enjoying some or most of the subsequent upside?

“In the hedging game, there is no free lunch,” according to Loukas.

There is a type of buffered exchange traded fund, known as a structured outcome ETF, that offers a stated amount of downside protection against the broad stock market. The ETF will also allow investors to enjoy either a capped amount of upside, or in the case of TrueMark’s TrueShares ETFs, an expected 70% to 80% of the upside, with no set limit.

The more downside protection you get, the more you will pay, because the funds will pay higher fees for larger hedges.

During an interview, Loukas called a 10% downside buffer a “sweet spot,” because having, say, 20% downside protection might be expensive enough to outweigh the advantages of lower volatility for long-term investors.

How buffered ETFs work

This type of ETF is “reset” each year. The TrueShares Structured Outcome (July) ETF was reset at the start of this month. The ETF primarily invests in the SPDR S&P 500 ETF Trust while “essentially selling put options at 10% below the market on the first day of each trading period,” according to Loukas.

So if you hold shares of JULZ for a year, through the end of June, and the S&P 500 is down 10% for that period, your return will be zero (before fund expenses) — your buffer will have covered that decline, and then the ETF will reset. What actually happened between July 1, 2020 and June 30, 2021 was that the S&P 500 returned 40.09% (with dividends reinvested), while JULZ returned 30.33%. So it captured 76% of the index’s upside.

That 10% buffer is before fees. For JULZ, annual expenses are 0.79% of assets. All ETF performance figures in this article are after fees.

Here are three competing buffered ETFs, which have upside caps against the performance of the S&P 500. The caps change annually. And like TrueShares, these companies have monthly series of buffered ETFs, and the caps will vary within each fund family. The July versions are listed with their current caps, followed by a comparison of returns for the four July ETFs over the past year.

  • The Innovator S&P 500 Buffer ETF – July has a 9% downside buffer and a 12% upside cap from July 1, 2021 through June 30, 2022, before annual expenses of 0.79%. The cap for the previous year was 17.1%.
  • The FT CBOE Vest U.S. Equity Buffer ETF – July has a 10% downside buffer and a current upside cap of 14.95%, before annual expenses of 0.85%. First Trust will announce the new cap for the next year in mid-July.
  • The AllianzIM U.S. Large Cap Buffer10 July ETF has a 10% downside buffer and an upside cap of 10.7%, before annual expenses of 0.74%. The previous cap was 16.1%.

Loukas was quick to point out that his approach, with no upside cap and an expected 70% to 80% of upside capture, wasn’t necessarily better than those of his competitors. For example, leaving aside expenses, if the S&P 500 were to return 8% in a year ended June 30 and JULZ captured 80% of that performance, the investors’ return would have been 6.4%. But for BJUL, FJUL and AZAL, investors’ returns would have been 8% — those ETFs capture the full return of the S&P 500 up to their respective caps.

It just so happens that Loukas’ approach worked best for the period of July 1, 2020, through June 30, 2021, because the S&P 500 had such an excellent run, with a 40% return:

Since the performance of the stock market can vary so much year to year, Loukas believes it’s important to capture as much upside as possible during the good years, to avoid “significant damage to the long-term return potential of a portfolio.”

You also need consider the emphasized importance of a one-year period with this type of buffered ETF: They reset every year.

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