Looking for the hottest new investment vehicle? Well, look no further. Buffer ETFs (exchange-traded funds) are currently one of Wall Street’s most popular offerings. Jason Zweig of The Wall Street Journal wrote, “In 2018, there were 13 of these funds managing a total of $3.8 billion, according to Morningstar; at the end of last month, 342 held a combined $108.3 billion.”
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But, for the uninitiated, what are buffer ETFs — and are they a good investment choice?
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First, here’s what exactly traditional ETFs are: a type of pooled investment security that holds multiple underlying assets, such as stocks and bonds. ETFs are similar to mutual funds, differing primarily in that they can be traded all day, like a stock — as opposed to only after the market closes.
Like most investments, however, ETFs are subject to market fluctuations.
Enter buffer ETFs — also known as defined outcome ETFs — which use options contracts to insure against some losses while capturing some gains. Yet, they aren’t without drawbacks.
GOBankingRates takes a look at the pros and cons of buffer ETFs, so you can adequately weigh the opportunity cost prior to diving in.
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The primary caveat with buffer ETFs is that, while they provide downside protection, they also limit an asset’s returns.
“To buy that buffer, or protection against loss,” wrote Zweig, “you relinquish your right to participate fully in the potential gains.”
For example, a buffer fund could hypothetically offer 50% protection against loss with a 7% upside cap. This means that you are shielded from losses if the market drops by up to 50%, but, if the market goes up 20%, you are still only entitled to a 7% return.
This could be a desirable investment for those entering retirement and not wanting to risk losing money at a time when they won’t be able to earn it back, or for individuals saving up for a down payment on a home and wanting to shield their savings from a potential market drop, while still retaining the possibility of growth.
In other words, if your time horizon is short and your risk profile is low, buffer ETFs could be a great option.