Investment Primer: The Defined Outcome (Buffer) Composite

Share

What, Why, and How of Defined Outcome (Buffer) ETFs

Defined Outcome ETFs, commonly known as “Buffer” ETFs, are funds designed to provide investors with exposure to an underlying asset while limiting, or “buffering,” potential losses over a specific period. The “why” is to offer a solution for risk-averse investors who want to participate in market growth but are concerned about volatility and downturns. They are often used to de-risk equity positions, especially for those nearing or in retirement.

The “how” is achieved through a portfolio of exchange-traded FLEX Options. These are customizable options contracts that the fund managers use to create a predefined range of outcomes. In the most common structure, the fund buys put options to create a “buffer” against a certain percentage of losses. To pay for this downside protection, the fund simultaneously sells call options, which creates a “cap” on its potential gains. This entire structure is designed to apply over a set timeframe, known as the outcome period, which is typically one year. The result is a more predictable, or “defined,” range of investment outcomes.

Deconstructing Defined Outcome Strategies

The world of buffer ETFs has expanded far beyond a single strategy on the S&P 500. The key differentiators are the underlying asset being tracked and the specific structure of the buffer and cap.

Underlying Asset Exposure

While the most common underlying asset is the S&P 500, buffer strategies are now applied to a wide range of markets, allowing investors to manage risk in various parts of their portfolio:

  • U.S. Equities: S&P 500, Nasdaq-100, Russell 2000, and equal-weighted indexes.
  • International Equities: Developed Markets (EAFE) and Emerging Markets.
  • Commodities: Gold.
  • Digital Assets: Bitcoin.

The Different Types of Buffer Structures

  • Standard Buffer: This is the most common structure, designed to protect against the first X% of losses in the underlying asset (e.g., a 9%, 10%, or 15% buffer). In exchange, returns are capped at a predetermined level.
  • Deep Buffer / Floor: For more conservative investors, these funds offer protection against a deeper range of losses, often after the investor absorbs the first few percentage points of a decline. For example, a fund might protect against losses from -5% down to -30%. This is designed to guard against a significant correction, but not a minor dip.
  • 100% Buffer (Defined Protection): These strategies aim to protect against all losses in the underlying asset over the outcome period. This complete downside protection comes with the trade-off of having the lowest upside cap.
  • Accelerator / Enhanced Buffer: These funds offer a more aggressive profile by providing magnified upside participation (e.g., 2x) up to the cap, often while still including a downside buffer.
  • Uncapped Buffer: This structure provides a downside buffer but has no cap on the upside. The trade-off is that the investor’s return is reduced by a “spread” (the cost of the options), or they must clear a performance hurdle before they begin to participate in the market’s gains.
  • Laddered / Fund-of-Funds: Instead of holding a single buffer ETF with one annual reset date, these funds invest in a portfolio of other buffer ETFs with different monthly or quarterly reset dates. This creates a smoother, rolling exposure to the strategy and avoids the need for an investor to time their purchase around a single outcome period.
  • Dynamic Buffer: These funds use a rules-based, tactical approach to adjust their level of downside protection based on market volatility (e.g., using the VIX index). They may automatically switch from a standard buffer to a deep buffer when volatility is high.

A Practical Guide to Locating Funds in the ETF Action Database

ETF Action’s classification system is designed to help users precisely identify the specific type of defined outcome strategy they are looking for.

3.1 Foundational Screening: Building the Initial Universe

  • Step 1: Select the Database. Navigate to the ETF, Mutual Fund, or other desired database.
  • Step 2: Filter by Asset Class. Select Non-Traditional.
  • Step 3: Filter by Composite. Select NT: Buffer
  • Step 4: Filter by Category. This is the key filter to identify the underlying asset (e.g., Non-Traditional: Buffer – Equity, Non-Traditional: Buffer – Crypto).
  • Step 5: Filter by Exposure. This is key to narrow in on the targeted market segment (e.g., U.S., Dev Ex-U.S., Total Market).
  • Step 5: Filter by Selection & Implementation. These fields are critical for this composite. The Selection filter allows you to specify the buffer range (e.g., Buffer: 0 – 15, Accelerator: 0 – 15). The Implementation filter allows you to specify the reset schedule (e.g., Buffer Reset: January, Buffer Reset: Quarterly, Buffer Reset: Laddered).

Advanced Filtering: Refining Your Peer Group

  • Beta Tracker ETF: Use this field to find all buffer funds linked to a specific underlying market (e.g., filter for “QQQ” to find all buffer ETFs that provide exposure to the Nasdaq-100).
  • Brand (Issuer), AUM, Expense Ratio, Liquidity: Use these standard filters to narrow the list to viable candidates.

A Framework for Evaluating Defined Outcome Funds

Evaluating these funds requires focusing on the specific terms of the defined outcome and understanding the trade-offs involved. The defined outcome is not a guarantee and is only fully realized if the fund is held for the entire outcome period.

The Critical Importance of the Outcome Period

The advertised buffer and cap only apply to investors who hold the ETF for the entire outcome period (e.g., from January 1 to December 31).

  • Buying Mid-Period: An investor who buys shares after the period has begun will have a different cap and buffer than what was stated at the start. The fund’s website provides a daily update of the “remaining cap” and “remaining buffer,” which is essential information for anyone considering a mid-period purchase.
  • Selling Mid-Period: An investor who sells before the outcome period ends will not receive the defined outcome. Their return will be based on the market value of the ETF at the time of sale, which will fluctuate based on the value of its underlying options and will not move in a straight line with the reference index.

Quantitative Analysis

  • Upside Cap: This is the maximum possible price return the fund can provide at the end of the outcome period. This cap is reset at the start of each new period and will change based on market conditions (higher volatility generally leads to higher caps).
  • Downside Buffer: This is the specific percentage range of loss the fund is designed to absorb. It’s critical to understand the buffer’s structure (e.g., does it protect against the first 10% of losses, or losses between -5% and -30%?).
  • Price Return vs. Total Return: Most buffer ETFs track the price return of an index, not the total return. This means investors typically forgo the dividend income from the underlying stocks, which can be a significant drag on performance over time.
  • Up/Down Capture Ratios: While the defined outcome is for the full period, looking at historical capture ratios can give a sense of how the fund has behaved in different market environments and the effectiveness of its hedge.

Qualitative Analysis

  • FLEX Options: These funds use exchange-traded FLEX Options to create their defined outcomes. While this provides customization, it also introduces complexity and a very remote counterparty risk with the Options Clearing Corporation (OCC).
  • Cap Reset Risk: The upside cap is not fixed forever. It is reset at the start of each new outcome period based on market volatility and interest rates at that time, meaning it could be higher or lower than the previous period’s cap.

Ready to Put This Knowledge to Work?

The best insights come from the best tools. Join ETF Action to screen, compare, and analyze thousands of ETFs with our premium suite of resources for serious investors.