Market Rallies Made Buffer ETFs Big Winners in 2022. Here's How they Work

There is no doubt that defined outcome and buffer ETFs proved their worth in 2022's bear market, but a murky market outlook for 2022 could make the use of these funds a little more complicated.

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As investors in 2022, buffer ETFs, offered by a number of firms, including First Trust, Innovator, and Allianz, will prove to be a successful investment strategy. By combining broad market exposure with an options strategy, the funds limit the potential upside while protecting investors from price corrections.

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Due to the fact that the strategies are designed to work over a full 12-month period, the funds are generally offered in series, with one available per month. A hypothetical investor who bought an ETF in January with a 20% buffer at the start of 2022 would have ended the year close to flat in spite of the large declines in the market that occurred during the course of the year.

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In order to drive sales of our products, we needed 2022 to drive eyeballs to them. As we said, they have done exactly what we told them they would do,” said Trevor Terrell, head of distribution at Innovator ETFs, and he has not been disappointed.

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There has been a sharp rally in the stock market in the early weeks of 2023, however. Consequently, this leads to underperformance on the part of the funds that rebalanced in January, since the defined outcome funds have a tendency to lag during market upswings, especially when they are many months away from the expiration of their derivatives contracts. There is a possibility that if the rally lasts past the cap, the funds could be in for a bad year if the rally continues.

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Investors may also experience downside risk due to the rally because the buffer applies to where the market was at the time of the fund's rebalancing, not when an investor purchased a share of the fund.

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Investing in a fund that has recently been rebalanced might be one solution for investors to address this issue, which would raise the buffer floor and cap level of the fund.

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Johan Grahn, head of ETFs at Allianz Investment Management, outlined a hypothetical scenario where if you bought an ETF on Jan. 1, and the market rose 5%, you would have received perhaps 2.5% of that increase. "Feb. 1st. By the time February 1st rolls around, you will be able to dump the January one, lock in the 2.5%, and you will now have a new buffer starting on February 1, as well as a new cap that lasts for the next 12 months."

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Undoubtedly, this tactic, like other short-term trading methods, may subject investors to tax penalties. Although the funds have a higher fee ratio and investors lose part of the assurance of the defined-outcome strategies, Innovator provides ETFs that will perform this rotation for investors inside the same fund, such as the Buffer Step-Up Strategy ETF (BSTP).

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According to FactSet, the BSTP fund is equally modest in size, with assets under administration of only roughly $30 million.

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Different kinds of defined outcome strategies might soon be available on the market as a result of the buffer funds' performance from the previous year. Head of institutional products and ETFs at Natixis Investment Managers, Nick Elward, stated that his company was looking into adding comparable products to its line-up.

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"I just believe that investors and advisers prefer the predictability of knowing they have that options overlay that may protect from a very severe downside and, in certain situations, even create some additional income," Elward stated.

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Accelerated ETFs, as described by Innovator, is one possible growth sector. For instance, the Innovator U.S. Equity Accelerate 9 Buffer ETF (XBJA) is made to offer investors a multiple of the market return up to a certain level as well as a 9% buffer. According to FactSet, the fund currently manages around $50 million in assets, with more than $30 million coming in this year.

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"We've noticed a significant increase in demand for our expedited items. No one, as far as I can tell, is forecasting an astronomical year of double-digit gains. If that occurs, fantastic; however, if we are range-bound, what better way to obtain that than through an accelerated type of product?" Terrell remarked.