'Buffer' Funds Protect Investors in Volatile Markets

Summary

Podcast Summary: WSJ Your Money Briefing

Episode: 'Buffer' Funds Protect Investors in Volatile Markets

Date: May 6, 2020
Host: J.R. Whalen
Guest: Misha Frankel Duvall, Wall Street Journal Reporter

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Episode Overview

This episode explores the growing popularity of buffer funds as a strategy for investors seeking protection amid the extreme market swings caused by the COVID-19 pandemic. J.R. Whalen talks with WSJ reporter Misha Frankel Duvall to unpack how buffer funds work, what protections and limitations they offer, and the trade-offs investors need to understand.

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Key Discussion Points & Insights

Understanding Buffer Funds

• Definition and Purpose:
  Buffer funds use options to track a particular index or ETF, offering investors protection against a specified level of losses if held to maturity.

  • “Effectively, these buffer funds use a suite of options to track an underlying index or etf, and they ensure that if they are held to maturity, investors are protected against a certain amount of downside.”
    — Misha Frankel Duvall [01:50]

• Downside Protection:
  A range of products offer varying degrees of protection—some covering 9%, 10%, or 15% of initial losses.

  • “Some offer 9, 10, or 15% against initial losses, and some offer a greater degree.”
    — Misha Frankel Duvall [02:05]

• Exposure After the Buffer:
  If market losses exceed the buffer level, investors will still experience losses, but only after the protected portion.

  • “If, over the set period, the market drops below the level of buffer, investors can be exposed to losses, but they should still be buffered against the first set proportion as advertised.”
    — Misha Frankel Duvall [02:21]

• Trade-Offs: Caps on Gains:
  In exchange for downside protection, there are limits on potential gains. Generally, the more downside protection, the lower the cap on profits.

  • “In exchange for this downside buffer, you also cap your gains at a certain level. And typically the higher... the more extreme the level of buffer, the lower the cap as well.”
    — Misha Frankel Duvall [02:53]

Additional Trade-Offs

• Lack of Dividends:
  Buffer funds often forgo dividends because they track price indices, not total return indices.

  • “Most notable is probably the lack of dividends, because in the case of some of these ETFs, they follow the S&P 500 price index...”
    — Misha Frankel Duvall [03:10]

• Underlying Assets:
  Investments are mainly in options that mirror indices like the S&P 500, Russell 2000, or NASDAQ.

  • “These funds typically invest in... options that track a liquid underlying. Normally... the S&P 500... Russell 2000, the NASDAQ, that kind of thing.”
    — Misha Frankel Duvall [03:30]

Recent Performance and Popularity

• Most Popular Buffer Funds (2020):
  • First Trust (Managed by CBO Vest):
    • Pulled in ~$425 million since its mid-to-late February launch.
    • Down about 5% versus the S&P’s 10% drop (at the time); full assessment possible only at the end of the outcome period.
      — Misha Frankel Duvall [03:50]
  • Innovator Fund:
    • Offers a 9% loss buffer.
    • The version launched in April of the prior year protected against an 8.8% S&P decline, effectively covering within the buffer as intended (before fees).
      — Misha Frankel Duvall [04:10]

Background & Suitability

• History of Buffer Funds:
  Publicly available since 2018, although similar products existed for institutional investors before.
  • “The first ETF became available to investors in 2018. Similar products have been available to institutional investors for a lot longer than that…”
    — Misha Frankel Duvall [04:45]
• Suitability for Investors:
  Buffer ETFs may appeal to those who want to know their maximum downside risk up front, but won't suit those seeking unlimited upside potential.
  • “If you're looking to have a known downside or at least a known level of protection, then buffer ETFs might suit your outlook. If you're looking to participate fully in gains beyond the level advertised, they won't do that for you.”
    — Misha Frankel Duvall [05:08]

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Notable Quotes & Memorable Moments

• Buffer Mechanics:
  “Investors can be exposed to losses, but they should still be buffered against the first set proportion as advertised.”
  — Misha Frankel Duvall [02:21]

• On Trade-Offs:
  “In exchange for this sort of defined outcome…you also cap your gains at a certain level.”
  — Misha Frankel Duvall [02:53]

• Dividends Discussion:
  “The dividends that you would receive if you held other types of tracker funds don't apply to you.”
  — Misha Frankel Duvall [03:10]

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Timestamps for Important Segments

• What are Buffer Funds? — [01:50]
• How Much Downside Protection? — [02:05]
• Exposure Beyond the Buffer? — [02:21]
• Caps on Gains and Other Trade-Offs — [02:53]
• Underlying Investments — [03:30]
• Popular Buffer Funds this Year — [03:50]
• Performance Review Example — [04:10]
• History of Buffer Funds — [04:45]
• Are Diversified Portfolios Still Recommended? — [05:00]
• Suitability for Investors — [05:08]

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Summary Takeaways

• Buffer funds use options to offer limited downside protection, with commensurate caps on gains.
• They have surged in popularity during the pandemic due to market volatility.
• Notable funds have provided partial insulation from sharp declines, but are best evaluated at the conclusion of their defined "outcome period."
• These funds are not for everyone; they suit investors seeking specific defined protections rather than those seeking full market upside or dividends.
• Diversified portfolios remain important, depending on individual investor outlooks and appetite for risk and reward.

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Host J.R. Whalen wraps up the episode thanking Misha Frankel Duvall, reinforcing the educational purpose and context of buffer funds for investors responding to turbulent markets.

Transcript

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[Retail Industry Representative]

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[Small Business Owner]

See banks and credit unions help small businesses make payroll. This bill would cut the vital resources

[Retail Industry Representative]

they need while increasing megastore profits. They deserve it, don't they?

[Consumer Advocate]

Tell Congress. Stop the Durbin Marshall money grab for corporate megastores paid for by the Electronic Payments Coalition.

[J.R. Whalen]

Here's your money briefing for Wednesday, May 6th. I'm J.R. whalen for the Wall Street Journal. The wild market swings we've seen during the pandemic are enough to make any investor, large or small, a bit queasy. Enter buffer funds. This kind of investment fund has surged in popularity in part because they protect investors against potential losses.

[Misha Frankel Duvall]

What can happen if, over the set period, the market drops below the level of buffer? Investors can be exposed to losses, but they should still be buffered against the first set proportion as advertised.

[J.R. Whalen]

That's Wall Street Journal reporter Misha Frankel Duvall. Coming up, he'll explain how buffer funds work and the trade offs that come with investing in them. During the pandemic, the s and P500 has been down down as much as 30%. In a volatile market like that, more investors are turning to a relatively new kind of fund, one that promises to ease their potential losses. It's called a buffer fund, and Wall Street Journal reporter Misha Frankel Duvall is here to tell us all about them. So, Misha, how do these buffer funds protect investors against losses?

[Misha Frankel Duvall]

So, effectively, these buffer funds use a suite of options to track an underlying index or etf, and they ensure that if they are held to maturity, investors are protected against a certain amount of downside.

[J.R. Whalen]

So to what degree are they protected?

[Misha Frankel Duvall]

So there are a range of products, and they offer different levels of downside protection. Some offer 9, 10, or 15% against initial losses, and some offer a greater degree.

[J.R. Whalen]

But what happens if the market suffers a drop beyond, let's say, the 10 or 15%?

[Misha Frankel Duvall]

The buffer products don't actually track directly on top of the underlying. But what can happen if, over the set period, the market drops below the level of buffer? Investors can be exposed to losses, but they should still be buffered against the first set proportion as advertised.

[J.R. Whalen]

Okay, so in this case, investors are protected against the first 10 or 15% in losses. But if the market keeps dropping, they could lose substantially more than just the loss limits.

[Misha Frankel Duvall]

It's possible, yes.

[J.R. Whalen]

Are there also caps on gains?

[Misha Frankel Duvall]

Absolutely. So the trade off is that in exchange for this sort of defined outcome, in exchange for this downside buffer, you also cap your gains at a certain level. And typically the higher the kind of, the more extreme the level of buffer, the lower the cap as well.

[J.R. Whalen]

What other trade offs are there?

[Misha Frankel Duvall]

So in exchange for the protection you get, you do give up some other benefits. And most notable is probably the lack of dividends, because in the case of some of these ETFs, they follow the S&P 500 price index. So that's not the total return index. And the dividends that you would receive if you held other types of tracker funds don't apply to you.

[J.R. Whalen]

What do these funds typically invest in?

[Misha Frankel Duvall]

So these funds typically invest in the majority or all of their assets in options that track a liquid underlying. Normally it can be the S&P 500, it can be an S&P 500 ETF, or it can be the Russell 2000, the NASDAQ, that kind of thing.

[J.R. Whalen]

Which of these funds has seen the most investment this year?

[Misha Frankel Duvall]

So the ETF that's pulled in the most this year is one issued by First Trust and managed by CBO Vest, which has pulled in about $425 million so far this year. Since it launched, which was in mid to late February, it's down about 5%. And since then the S and P is down about 10%. But the time to really judge will be at the end of the outcome period. That's when the buffers that attach to the fund will be fully effective. Another popular buffer fund is one offered by Innovator that tracks the S&P 500 while offering a buffer against 9% of losses. The version of that that was launched last April completed its outcome period in the April just gone, and it performed as its issuers would have expected, less fees. It was at zero after the outcome period, and during that time the S&P 500 fell about 8.8%. So within the buffer now, these funds

[J.R. Whalen]

can offer safety and some stability in a volatile market. Have they been around since before the pandemic?

[Misha Frankel Duvall]

They have been. They haven't been around very long. The first ETF became available to investors in 2018. Similar products have been available to institutional investors for a lot longer than that, but they've only become available in these more investor friendly wrappers a little bit more recently.

[J.R. Whalen]

Now, while this might give investors some peace of mind when you're playing the long game, aren't diversified portfolios still recommended?

[Misha Frankel Duvall]

It really depends on the investor's appetite, I would say that both have their merits, and it very much depends on your outlook. If you're looking to have a known downside or at least a known level of protection, then Buffett ETFs might suit your outlook. If you're looking to participate fully in gains beyond the level advertised, they won't do that for you.

[J.R. Whalen]

All right. That's Wall Street Journal reporter Misha Frankel Duvall. Misha, thanks for coming on the show.

[Misha Frankel Duvall]

Thank you for having me.

[J.R. Whalen]

And that's your Money briefing. I'm J.R. whalen for the Wall Street Journal.

[Small Business Owner]

Access to affordable credit helps me pay my employees, but I don't really need it.

[Retail Industry Representative]

Infliction is killing me, but who cares? Big retailers are making record profits. That's why we support the Durbin Marshall credit card bill.

[Small Business Owner]

See, banks and credit unions help small businesses make payroll. This bill would cut the vital resources

[Retail Industry Representative]

they need while increasing megastore profits. They deserve it, don't they?

[Consumer Advocate]

Tell Congress, stop the Durbin Marshall money grab for corporate megastores paid for by the Electronic Payments Coalition.