Looking for the hottest new investment vehicles? Well, look no further. Buffer ETFs (exchange traded funds) are currently one of the most popular products on Wall Street. Jason Zweig of the Wall Street Journal writes: “According to Morningstar, 13 of these funds managed a total of $3.8 billion in 2018. As of the end of last month, the 342 companies held a total of $108.3 billion.”
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But for beginners, what are buffer ETFs and are they a good investment option?
Current trends:
First, let’s explain what exactly a traditional ETF is. A type of pooled investment security that holds multiple underlying assets such as stocks and bonds. ETFs are similar to mutual funds, but the main difference is that they can be traded throughout the day like stocks, rather than only after the market closes.
However, like most investments, ETFs are subject to market fluctuations.
Entering a buffer ETF (also known as a defined outcome ETF) allows you to use option contracts to insure against losses while capturing some profits. However, it is not without its drawbacks.
GOBankingRates looks at the pros and cons of buffer ETFs so you can properly weigh the opportunity costs before you get started.
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The main caveat with buffered ETFs is that while they provide downside protection, they also limit the return on the assets.
“To purchase a buffer, or protection against loss, you are giving up the right to fully participate in potential profits,” Zweig wrote.
For example, assume that a buffer fund can provide 50% loss protection with a 7% appreciation cap. This means that if the market goes down by up to 50%, you won’t lose, but if the market goes up by 20%, you’ll still only get a 7% profit.
This can be a desirable investment for people who are nearing retirement and don’t want to risk a loss if they can’t get their money back, or for people who have saved up for a down payment on a home and want to protect their savings. Avoid potential market declines while preserving growth potential.
In other words, if your time horizon is short and your risk profile is low, buffer ETFs may be a better option.
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However, as conventional wisdom suggests, maintaining a portfolio’s content over time usually leads to growth.
“In every 12-month period since 1970, the U.S. stock market has risen 80% of the time, with an average return of 12.3%,” Zweig wrote. By buying funds that limit growth, investors can keep a lot of money in their pocket.
Additionally, “Buffer ETF investors typically do not receive dividends, but dividends have helped the S&P 500 return up to 2.2% annually over the past 20 years,” writes CNBC’s Kate Doerr.
“With annual expenses typically less than 1% and no fees,[buffered]ETFs are much cheaper than fixed annuities or the complex debt products called structured notes that Wall Street is relentlessly selling,” Zweig wrote. are. “It’s less risky than stocks alone, there’s no risk of default, and it’s tax efficient.”
That’s wonderful. Well, maybe so. But be sure to read the fine print.
Buffer ETFs have a period called the “outcome period,” which traditional ETFs do not have. This means that full protection and full benefits only apply if an investor buys and holds a buffer fund for a certain period of time (usually one year).
“If you buy in the middle of an outcome period, you may not get full upside exposure,” Dore wrote. “Similarly, selling before the end of the outcome period may limit downside protection.”
Additionally, Buffer ETFs have slightly higher fees than traditional ETFs, averaging 0.8% for Buffer ETFs compared to 0.51% for the average traditional ETF.
Buffer ETFs can be a great investment for people who want to avoid losing a lifetime of savings in a market crash and want to sleep better at night. However, buffer ETFs do not offer the greatest returns in the long run.
As with most financial decisions, consider your personal goals, risk profile, and time horizon before pulling the trigger. And, of course, always check the terms and conditions.
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This article originally appeared on GOBankingRates.com: Should you invest in Buffer ETFs? 2 pros and cons you should know
