Buffer ETFs can shield investors from some losses. Here's what to know before investing

• Buffer exchange-traded funds, also known as defined-outcome ETFs, use options contracts to limit losses while capping upside potential.
• As of August 2024, there were 327 buffer ETFs, representing more than $54.8 billion in assets, up from 73 ETFs and roughly $4.6 billion in August 2020, according to Morningstar Direct.
• But buffer ETFs are complicated and more costly than traditional ETFs, experts say.

If you're seeking refuge from market volatility, so-called buffer exchange-traded funds provide some downside protection. But these ETFs also limit upside potential and come with higher fees, experts say.  

Buffer ETFs, also known as defined-outcome ETFs, use options contracts to offer investors a pre-defined range of outcomes over a set period. The funds are tied to an underlying index, such as the S&P 500.

These funds have been "one of the fastest-growing areas of the ETF market" over the past five years, with demand surging in 2022 as investors faced correlating losses from stocks and bonds, said Bryan Armour, director of passive strategies research for North America at Morningstar. 

As of August 2024, there were 327 buffer ETFs, representing more than $54.8 billion in assets, up from 73 such ETFs and roughly $4.6 billion in August 2020, according to data from Morningstar Direct. 

The funds create a 'buffer zone'

Buffer ETFs have an "outcome period," which only applies if investors buy and hold the fund for a set window, typically one year.

During the outcome period, the funds have "a buffer zone" that protects investors from some losses and caps returns above a certain threshold, Armour explained.

For example, a buffer ETF could shield investors from the first 10% of losses while limiting upside returns to 15%. However, you may not get full upside exposure when buying midway through the outcome period.

Similarly, selling before the outcome period ends could limit downside protection.

"People need to be aware that if they buy and sell during that period, they might not be getting what they think they're signing up for," Armour said.

Plus, buffer ETF investors typically don't receive dividends, which have contributed up to 2.2% annual returns to the S&P 500 over the past 20 years, according to Morningstar.

Another downside is the assets have higher fees than traditional ETFs, with 0.8% for the average buffer ETF compared to 0.51% for the average ETF, Armour said.

Overall, the biggest drawback is "opportunity cost," depending on your alternative investment options, he said.

The benefits of buffer ETFs

Despite the trade-offs, buffer ETFs could be attractive to more conservative investors, depending on their goals, risk tolerance and timeline, experts say.

"I really like these buffered ETFs and have been using them for client portfolios for a while," said certified financial planner David Haas, president of Cereus Financial Advisors in Franklin Lakes, New Jersey.

On top of some downside protection and market exposure, buffer ETFs also offer "immediate liquidity" if you need access to the cash, he said.

Armour said the ETFs could work best for investors with "low risk tolerance" and a shorter timeline, so long as they understand how this asset works.