Could This ETF Be Your Knight in Shining Armor?

Imagine earning much of the upside in stocks while avoiding the downside. That's the idea behind a growing class of mutual funds and exchange-traded funds (ETFs) that use options contracts to minimize losses while capturing some gains. These funds have seen a remarkable rise in popularity, increasing from just 13 funds managing $3.8 billion in 2018 to 342 funds managing $108.3 billion by the end of last month, according to Morningstar.

‍

These funds are known by many names, such as buffer funds, defined-protection funds, defined-outcome ETFs, and target-outcome ETFs. However, a fitting nickname might be “armored funds” because they act like protective armor for investors, much like a knight’s shining armor shielding against market volatility. For instance, they can guard against significant stock market declines, like the 18.1% loss seen in 2022.

‍

Yet, just like armor can be cumbersome, these funds come with limitations. To gain that protection against market losses, investors give up the opportunity to fully participate in the potential market gains. Your returns are capped at a predetermined level, which is an essential trade-off to consider before investing in these funds.

‍

There are some attractive aspects to armored ETFs. They typically have low annual expenses, usually under 1%, and they don’t charge commissions. Additionally, these funds are more affordable compared to alternatives like fixed annuities or complex structured notes that Wall Street often promotes. They are also less risky than holding stocks alone, carry no risk of default, and are tax-efficient.

‍

These funds may appeal to people who are looking to protect their investments while still having the chance to benefit from some market growth. For example, if you’re planning to make a large purchase, like a home down payment in the next few years, you may want to safeguard your savings from potential market downturns while hoping for modest growth. Similarly, if you’re approaching retirement and can’t afford a major loss that could take years to recover, these funds might make sense.

‍

However, it’s crucial to be aware of their limitations. While armored funds can provide downside protection, the Federal Reserve’s recent interest rate cuts could make some of these funds less attractive. If interest rates continue to fall, the potential upside for these funds may shrink. According to Bruce Bond, the founder of Innovator ETFs, which launched the first buffer ETFs in 2018 and now manages $18.5 billion in armored funds, declining interest rates reduce the amount of capital new ETFs can allocate to options, making it harder for them to offer substantial gains.

‍

Armored ETFs generally operate over a one-year period. They use a combination of stock market investments and options to provide a buffer against losses and cap gains at a certain level. At the end of the 12 months, the fund resets its terms, and investors can choose to stay or exit with any gains they've earned.

‍

Take First Trust’s FT Vest U.S. Equity Max Buffer ETF – July, launched in July 2023. It offers 100% downside protection with an 8.45% upside cap, shielding investors from any S&P 500 losses (before fees) if held until July 2025. However, the upside is limited. If the S&P 500 returns 15%, you would only get 8.45%, and you’ll need to subtract the fund’s 0.85% expense ratio. On the flip side, a new ETF launched in September 2023 offers only 50% downside protection with a 7% cap, reflecting how interest rate cuts can impact potential gains.

‍

During the global financial crisis from October 2007 to March 2009, the S&P 500 fell 56.8%. If something similar happened again, an armored fund with 50% protection would shield you from half of the losses, but you would still experience around a 7.7% decline, after factoring in expenses.

‍

If a fund offers less than 100% protection, it will be more volatile in down markets, which might surprise investors looking for more stability. According to Matt Kaufman, head of ETFs at Calamos Investments, such funds could be "a lot more volatile in down markets," which might not align with investors' expectations for these types of products.

‍

Financial advisers often pitch armored ETFs as a "bond substitute," but they don’t offer the same diversification benefits as bonds. Since these funds track the stock market closely, they don’t provide the same protective cushion that bonds can offer. Rachel Aguirre, head of U.S. iShares product at BlackRock, suggests thinking of armored ETFs as an alternative to cash, rather than a bond replacement.

‍

It’s important to note that the returns you get from armored funds depend on when you buy and sell. As Innovator’s Bruce Bond points out, "there’s no free lunch" with these funds. If you invest after the fund has started or sell before the annual reset date, you might experience losses or miss out on the full capped returns.

‍

Take the COVID-19 market crash in early 2020, for example. As the S&P 500 dropped 30.8% between February and March, the FT Vest U.S. Equity Buffer ETF – February lost 22.8%. If you had sold during that period, you would have locked in significant losses.

‍

Finally, it's essential to consider the opportunity cost. If you cap your returns at 7%, you miss out on higher potential gains. Historically, the U.S. stock market has risen about 80% of the time over rolling 12-month periods since 1970, with an average return of 12.3%. By limiting your upside, you sacrifice the chance to fully benefit from the market's long-term growth.

‍

In summary, while armored funds can offer valuable protection, they come with costs. Make sure you understand the trade-offs and whether you’re willing to forgo higher gains in exchange for shielding your investments from potential losses.

‍