Having it all with Buffer Funds?

I’m proud to say that Acropolis was an early adopter of exchange-traded funds (ETFs). Although they had been around for almost ten years by the time we launched the firm, they were not actively used.

In fact, five years before we launched Acropolis, I wanted to buy some in an account that I had with my dad’s broker at A.G. Edwards. I wanted to buy the S&P 500 ‘Spider’ fund (ticker: SPY), and some of the World Equity Benchmarks (WEBs) that were offered by the firm that is now iShares.

When I told this broker what I wanted to buy, he said, ‘David, I’ve seen a lot of dumb stuff come and go in my career, and buying some spiderwebs sounds pretty stupid.’

While I have no doubt that he had seen a lot of dumb stuff over the decades, and no doubt avoided a lot of bad stuff, you can see why I joined Chris and Dannelle!

Well, 25 years later, I feel a little bit like that old-timer because I look at a lot of the ETF offerings and think there are a lot of dumb ideas out there.

One of the hottest areas of the ETF industry today is a series of ETFs known as ‘buffered’ funds. They sound pretty good because they promise to offer participation in the upside of the market (usually the S&P 500, but others too), and ‘buffer’ the downside. Sounds good, right?

In the three years since the first buffer fund ETF launch, another 70 or so have been formed, and the top five funds have nearly $15 billion in assets under management.

Although I admit to researching buffer funds with the wary (and weary) eye of my dad’s seasoned broker, I’m not really impressed.

I wouldn’t go so far as the broker to call buffer funds ‘dumb’ or even a bad investment, but my conclusion is that they don’t accomplish much more than the classic stock/bond strategy that we’ve pursued since our launch in 2002. In fact, so far, the data suggests that the buffer funds provide less, but they’ve only been around for a few years, so I’ll give them some benefit of the doubt.

As I noted above, the broad concept of a buffer fund is to capture some market upside while avoiding some downside, and they accomplish this using options.

The buffer funds are often complicated and offer a dizzying array of choices, but broadly speaking, they sell call options to generate some cash and use that cash to buy put options. There is nothing new about this – options investors have done it for decades in the form of ‘structured notes’ for retail investors.

I’ll get to my biggest issue with buffer funds in a minute, but let me start with some of the ‘smaller’ problems.

First, I don’t think investors really understand what they’re getting. Maybe I’m not giving investors enough credit, but I think what people hear is, ‘I get the upside of the market and not the downside.’

Well, it’s not that simple. One of the larger buffer ETFs out there offers a 15 percent buffer from losses and the upside return is capped at 11.75 percent. What that means is that investors won’t lose any money as long as the losses are less than 15 percent, and if the market goes up, they get all of the gains until the cap of 11.75 percent.

What if the market loses 25 percent? The investor loses 10 percent. What if the market loses 90 percent like in the Great Depression? Investors lose 75 percent. Okay, we’re probably not in for another Great Depression anytime soon, but what about the 50 percent losses that we’ve seen twice in the history of Acropolis? Yep, that’s a 35 percent loss for buffer fund investors.

Despite all of the discloses that go with these funds (and they are lengthy!), I think that most people think that their losses are capped at -15 percent, not that the ‘buffer’ protects them from those losses and not the losses beyond 15 percent.

So, with a buffer fund, even though you’re protected from the first losses up to some level (and, importantly, over a specific period), you have a lot of downside exposure – lots of risk. And what’s the upside for taking that risk? It’s 11.75 percent, in this case. I don’t like that asymmetry.

In a way, it’s the opposite of short-selling, where the upside is limited to 100 percent, and the downside is unlimited. Not great. Just ask the folks on the other side of the GameStop traders.

Or, it would be like all the exposure of going without health insurance, except having someone cover your deductible. Uh, I need protection from the $1 million hospital stay, not the $1,000 deductible.

My second issue with the buffer funds is that the returns are all tied to the price of the S&P 500, not the total return. Although we think of dividends as small at 1.5 percent, if you think that the return will be 10 percent over time, that’s 15 percent of the return.

And, if you’re like me and think that returns over the next decade will be lower than the historical average, then the dividend is an increasingly large and important part of the return.

And the last issue is the complexity of buffer funds. Not just the underlying complexity of trading options and other derivatives inside the fund, but the number of issues that you have to consider as an investor.

For example, the cap and the buffer change over time at fixed intervals, with implications for investors. If you want to buy a fund on June 30 that’s halfway through its interval period, the buffer and cap apply to what happened on Jan 1st, the first day of the period.

If a fund with a 15 percent buffer is down -10 percent on June 30th, the buffer for you as a new investor is only five percent. If the cap is 11.7 percent, and the market is up 15 percent, there’s no more upside.

It looks like the fund companies offer funds for each month to help deal with this problem, so if you’re trying to include buffer funds in a diversified portfolio, you’ll probably end up with a bunch of funds over time. Maybe that’s optimal – maybe the best idea is to own 12 buffer funds, I don’t know.

If buffer funds did something really unique and wonderful, I’d be tempted to figure it out, but so far, investors would have been better off in a 60/40 mix of stocks and bonds.

Morningstar wrote a great article on the topic, and it’s one of my primary sources for this article. You can find the whole article by clicking here, but I also want to include a chart that they produced and included in the article:

Since the inception of these funds, just over three years ago, you can see that the return of a 60/40 blend of the S&P 500 and Barclays Aggregate produced higher returns with less volatility. Of course, that’s a short time period, but it does include the pandemic selloff and recovery.

In that period, buffer funds lost an average of 19.4 percent, compared to the S&P 500, which lost 33.5 percent, according to Morningstar. The buffer fund loss is hardly different than what the 60/40 stock/bond portfolio lost. Morningstar also reports that the buffer funds only gained 10 percent in the recovery through the end of November, but the market was up 20 percent, which means that the 60/40 mix did better.

I’ll probably check in on buffer funds every few years, but my conclusion at this point is that the juice isn’t worth the squeeze. The good old fashion, albeit boring-sounding, stock/bond mix probably makes more sense.

That’s not to say that the 60/40 mix will always do better – it’s easy to imagine how a surprise interest rate shock would hurt stocks and bonds at the same time, and the buffer funds might get some protection from the stock selloff without the exposure to bonds that hurts the 60/40 investors. But that’s a pretty specific outcome, and, again, I doubt that most buyers of buffer funds have that specific hedge in mind.

We’re going to keep going with our classic approach, but continue to look at and evaluate all of the tools that are available to us in the market-place. Naturally, if we find something that we think looks better, we’ll start to apply it to our portfolios and yours.

I hope I never get too seasoned to reflexively say no to an idea without looking at it and thinking about it – I don’t want to miss out on the next great spiderwebs!