Defined outcome and buffer ETFs proved their worth in 2022’s bear market, but a murky market outlook for 2022 could make using the funds a bit more complicated for investors. Buffer ETFs — offered by several firms, including First Trust, Innovator, and Allianz — were a winning strategy for investors in 2022. The funds work by combining broad market exposure with an options strategy that creates a cap on potential upside in exchange for protecting investors from price pullbacks. The funds are generally offered in series, with one for each month, as the strategies are designed to work over a full 12-month period. For example, an investor who bought a January ETF with a 20% buffer at the start of 2022 would have ended the year close to flat despite the large market declines. “We needed a 2022 to drive eyeballs to our products. And they’ve done exactly what we said they were going to do,” said Trevor Terrell, head of distribution at Innovator ETFs. But in the opening weeks of 2023, the market has rallied sharply. That creates underperformance for the funds that rebalanced in January, because the defined outcome funds tend to lag during market upswings, especially when they are many months from the end of their derivatives contracts expiring. And if the rally continues past the cap, the funds could be in for a terrible year. The rally also creates downside risk for investors, since the buffer applies to where the market was when the fund rebalanced, not when an investor bought a share of the fund. One way for investors to address this problem is to switch into the fund that most recently rebalanced, which would move up the buffer floor and the cap level. “If you bought on Jan. 1, and the market moves up 5%, you got maybe 2.5% of that,” said Johan Grahn, head of ETFs at Allianz Investment Management, using hypothetical numbers. “Feb. 1st rolls around, you can dump the January one, lock in that 2.5% and now you have a new buffer starting Feb. 1, and a new cap that goes out the next 12 months.” To be sure, this strategy could create tax penalties for investors, just like other forms of short-term trading. Innovator has ETFs that will do this rotation for investors within the same fund, such as the Buffer Step-Up Strategy ETF (BSTP) , though the funds have a higher expense ratio and investors lose some of the certainty of the defined-outcome strategies. The BSTP fund is also small, with about $30 million in assets under management, according to FactSet. The success of the buffer funds last year could lead to different types of defined outcome strategies coming to market soon. Nick Elward, head of institutional products and ETFs at Natixis Investment Managers, said his firm was exploring adding similar products to its lineup. “I just think investors and advisers like the predictability of knowing they have that options overlay that can protect from a very significant downside, and in some cases also generate some more income,” Elward said. One potential growth area is what Innovator calls accelerated ETFs. The Innovator U.S. Equity Accelerate 9 Buffer ETF (XBJA) , for example, is designed to give investors a multiple of the market return up to a limit while also providing a 9% buffer. The fund has about $50 million in assets under management, according to FactSet, with more than $30 million in inflows this year. “We’ve seen a lot more interest in our accelerated products too. I don’t think anybody’s calling for a crazy year of double-digit returns. If that happens, awesome, but if we are range bound what better way to get that than through an accelerated type of product,” Terrell said.
