Buffered ETFs gain steam in valuation-wary markets

As a new round of U.S. tariffs send markets tumbling, could a once-overlooked ETF hedge offer investors the safety net they’re seeking?

Buffered ETFs, also known as defined outcome products, have gained traction in recent years by offering partial downside protection in exchange for capped gains. Each fund is structured to shield investors from a set percentage of losses, typically 10% to 20%, over a fixed period. In return, gains are limited, and the terms reset at the end of each outcome window.

Buffered ETFs struggled to gain traction after their late 2018 debut — and for good reason. From 2019 through 2021, the S&P 500 returned an average of 24% annually, leaving little appeal for products that cap upside. But a sharp downturn in 2022 changed the equation. With the index falling nearly 20% that year, investors poured nearly $10 billion into buffered ETFs, breathing new life into the once-overlooked product.

READ MORE:Top 10 dividend stocks of the past yearThe case for investing in emerging markets, despite underperformanceThe ‘granular’ investing strategy with big tax savings for HNW clientsWall Street builds S&P 500 ‘no dividend’ fund in new tax dodge

During times of declining equities, investors often rely more heavily on bonds. But in recent years that strategy hasn’t always worked out, according to Charles Champagne, head of ETF strategy at Allianz Investment Management.

“When you have an equity and fixed income portfolio, if equities are in a tougher market, you expect your fixed income to offset those losses, and that just really hasn’t happened in the past [couple of years],” Champagne said. “So these products really help in that capacity.”

To build buffered ETFs, issuers like Allianz use options to shape both downside protection and upside limits. They start by buying a deep-in-the-money call to mirror market exposure. Then, to create the buffer, they buy an at-the-money put and sell an out-of-the-money put, defining how much loss the fund will absorb. To offset the cost of this protection, they sell a call option, which in turn sets the cap on gains. This options mix allows issuers to offer defined outcomes over a set time frame, typically one year.

While buffered ETFs offer downside protection, their complex structure and active management often result in higher fees. 

First Trust and Innovator dominate the market, with flagship products like BUFD and PJAN charging expense ratios of 0.95% and 0.79%, respectively. Smaller issuers such as Allianz offer slightly lower costs — its most popular fund, JANW, carries a 0.74% fee — but costs remain high compared to the rest of the ETF market.

Champagne said he expects those ratios to decline as the funds grow, but that will take time.

“There is a cost to us managing these portfolios that we have to apply to the expense ratio. And then, like anything, economies of scale will eventually start to kick in,” Champagne said. “And as assets continue to drive towards defined outcome ETFs, that will inevitably draw down that total cost to the investor through the expense ratio. But anytime you’re dealing in options or exotic investments, there are additional costs that are factored into the total cost of the ETF.”

High costs aren’t the only deterrent for some advisors when considering buffered ETFs. Carson McLean, the founder of Altruist Wealth Management in Charlotte, North Carolina, said that buffered ETFs often “overpromise and underdeliver” when it comes to real-world investing behavior.

“They introduce complexity, hidden trade-offs (like forgone dividends and capped returns), and a timing dependency that most investors don’t fully grasp,” McLean said. “In my view, it’s risk repackaging more than risk reduction.”

Advisors like Kyle Ray, the founder of Ridgeback Wealth Management in Peachtree City, Georgia, share a similar view of buffered ETFs.

“I am not a fan of buffered ETFs for several reasons,” Ray said. “They can be complex, costly and tax-inefficient due to short-term capital gains resulting from frequent options trading. Additionally, they carry liquidity risks and other drawbacks.”

More than one way to hedge

For clients looking for downside protection, well-worn strategies are often still the best option, according to some advisors. 

McLean says a traditional bond-equity mix can still work well, especially when combined with thoughtful planning, disciplined rebalancing and guidance that keeps clients steady during market swings. With this approach, it’s crucial to match the portfolio structure to the actual spending needs and time horizon of the client, he said.

“That may not sound exciting, but it tends to work better than most engineered products,” McLean said.

Another approach involves using TIPS (Treasury inflation-protected securities) to build a laddered bond portfolio. With TIPS ladders, advisors purchase bonds that mature at regular intervals (often annually), helping to create a predictable stream of inflation-adjusted income over time.

“While I do not advocate for timing market entries, now is a good time to assess whether you need high equity risk to achieve your financial goals,” Ray said. “Currently, real yields on a 30-year ladder of TIPS are 2.4% above inflation. Purchasing a 30-year TIPS would be expected to more than double in real purchasing power if held to maturity. With real yields this high, investors should seriously consider whether they would get a fine result with fewer equities and less stomach acid.”

Investing with the right mentality

Beyond the specific strategy, advisors say it’s crucial to have the right mentality when it comes to long-term investing and the challenges it presents. 

“The bottom line answer is that no matter how you feel about market valuations, the market can either stay irrational a lot longer than you expect, or alternatively, corporate earnings can catch up with lofty valuations, bringing them back down to reality. Case in point are the earnings of companies like Meta and Microsoft,” said Alex Caswell, a financial planner at Wealth Script Advisors in San Francisco.

“I would encourage investors to think primarily about the risk/reward balance in their entire portfolio and commit to a long-term holding mentality,” he added.”