In uncertain times, are buffer ETFs coming to the fore?

With concerns around inflation and stock-bond correlations, structured strategies offer benefits

In uncertain times, are buffer ETFs coming to the fore?

Given the challenges brewing in the financial markets, advisors are looking for different solutions to provide protection within their clients’ portfolios. And while various alternative asset classes and strategies are getting increased attention, buffer ETFs are also experiencing their time in the sun.

“Across our platforms, it’s certainly been amongst our best-selling products year-to-date,” says Karl Cheong, Head of Distribution at First Trust Canada. “We expect going forward, there will be a lot more emphasis on these types of downside protection products given the challenging environment of losses across all asset classes and higher overall correlations between equities and bonds … this is exactly what these solutions were designed for.”

Things were certainly different when the firm first introduced its buffer ETF solutions in 2019, as the broad equity markets were delivering healthy returns. Even as recently as last year, conditions were relatively constructive: inflation still hadn’t set in, the fiscal spending faucets were still gushing, and central banks like the Federal Reserve were still not pulling back from their historically accommodative positions.

“As a firm, we believe there are certain clouds on the horizon going forward, given the elevated inflation rates which, rather than being temporary, we believe will be a significant factor for the first time in several decades,” Cheong says.

Traditional balanced portfolios aren’t providing the protection they used to either, as equities and bonds are falling in tandem. According to Cheong, the S&P 500 was down over 9% for the year until May 4; the 60/40 benchmark portfolio according to YCharts fared just as poorly, down over 9% during the same period. In comparison, the first S&P 500 Buffer ETF First Trust issued in August 2019 was down just over 6%.

With inflation overshadowing other considerations in advisors’ portfolio management decisions, many are buying treasury-inflation protected securities or real-return bonds. But even as the income those instruments throw off rises, the products themselves have declined by more than 10% because of their very long durations.

“2020 and 2021 really spoiled us in terms of return expectations, and I think we’re in for some really challenging times that a lot of advisors haven’t had to deal with,” Cheong says. “We have a great story to tell and we need to communicate that story to advisors going forward, because they're going to need differentiated returns and product solutions to add value to not just a portfolio, but as a value add relative to other advisors well.”

Aside from providing information and awareness about how they can be positioned in portfolios, First Trust’s education campaign on buffer ETFs also offers pointers on how their features and benefits can be communicated to clients. While many advisors tend to get deep into the specifics and complicate their explanations, Cheong encourages them to simplify discussions by focusing on the core benefit and putting the solution in perspective.

One useful approach, he says, is to look at analysts’ expectations of broad market returns by the end of the year; he says the February cap offered by the First Trust buffer ETF (TSX:FEBB.F) for example, exceeds year-end 2022 S&P 500  Wall Street projections by a healthy margin. That, coupled with a 10% downside protection feature, means the buffer ETF provides investors an opportunity to participate fully in the upside of the equity markets as per strategist projections, while lowering the volatility that may result from extreme downturns.

“We’ve brought this solution to market within an 81-102 regulated fund structure. We’re not using leverage, and it’s fully funded,” Cheong says. “Buffered ETFs are relatively new, but structured-return instruments have been around for decades, and they’ve consistently delivered. These are just offered in a different wrapper with different tax implications.”