What are Buffer ETFs?

Written by Emily Doak, CFA®
Director of ETF Research,
Charles Schwab Investment Advisory, Inc.

Buffer exchange-traded funds (ETFs) offer a potential solution to a well-known problem in behavioral finance,
which is that many investors find losses to be much more distressing than missing out on potential gains.

Accordingly, buffer ETFs have become one of the fastest growing corners of the ETF market. Since 2018, over 100
buffer ETFs have been launched, and they’ve attracted over $14 billion in assets.¹

But it’s important for investors to understand that covering structured products in an ETF “wrapper”—which is what buffer ETFs are, in a nutshell, as we’ll explain below—doesn’t make them any less complex. Investors
should be prepared to fully unwrap any investment product they are considering investing in, before making
the investment.

The story starts with structured products

“Structured products” refers to packages of derivative contracts tied to other assets or metrics in the broader
financial markets, such as equity indexes, credit spreads, interest rates, commodity prices, etc. Traditionally,
structured products have been offered by large investment banks to both retail and institutional investors.
These packages of derivatives offer investors unique patterns of returns in structures (often medium-term
notes or insurance contracts) that are more convenient, and potentially more tax-efficient, than holding derivatives
contracts directly.

While they often sound great, structured products historically have come with some significant drawbacks.
They can be expensive and often have opaque fee structures. They can be complex and difficult to value.
They often contain credit risk, which means that they depend on large investment banks standing behind
certain promises, and, in most cases, they lack secondary market liquidity, making them nearly impossible to sell
before maturity.

Enter the ETF wrapper

Recently, fund sponsors have begun enclosing structured products within the ETF “wrapper,” believing they can
offer the same strategies with greater transparency, more secondary market liquidity, and lower credit risk
than traditional types of structured products. Buffer strategies were the first, and are currently the most
popular structured product strategy to be offered in an ETF wrapper.

Buffer ETFs are funds that seek to provide investors with the upside of an asset’s returns (generally up to a capped
percentage) while also providing downside protection on the first predetermined percentage of losses (for example,
on the first 10% or 15%).

Most of the buffer ETFs currently on the market have a one-year outcome period, meaning that the caps and
buffers (as stated) apply only to investors who purchase on the rebalance date and hold the ETF throughout the
entire outcome period. Investors who purchase after the rebalance date will receive different caps and buffers based
on the performance of the referenced index between the rebalance date and when they purchased the fund. Fund
sponsors usually post the remaining buffers, caps, and days in the outcome period on funds’ websites.

Buffer ETFs are built with flexible-exchange, or “FLEX,” options. Like other types of options, FLEX options give
their buyers the right, but not the obligation, to buy or sell a security at a set price in the future. Like other
options, they are guaranteed, or “cleared,” by the U.S. Options Clearing Corporation (OCC), a self-regulatory
organization monitored by both the Securities and Exchange Commission (SEC) and the Commodity Futures
Trading Commission (CFTC), and funded through the fees of member exchanges. This should provide FLEX
options with lower counterparty risk than private swaps or other types of customized derivative contracts used in
traditional structured notes, due to centralized clearing through the OCC.

Buffer strategies are still complex

However, whether offered as a traditional structured note or as an ETF, buffer strategies can still be complicated.
Typically, there are three layers to a buffer ETF’s strategy:

First, the fund obtains synthetic exposure to an index by buying and selling options.
Second, the fund creates a downside buffer by purchasing a put option, which gives it the right to sell its exposure if the index declines in value. This is typically the most expensive part of the strategy, and it necessitates the third layer.
Third, the fund sells options to “finance” the purchase of this put. Typically, the fund will sell both a call option (which caps its upside potential) and a put option with a strike price lower than the put purchased (which resumes downside participation).

The components of buffer ETF return

At the end of the outcome period, or the date on which all the options expire (usually 12 months), a buffer ETF will roll
into a new set of options contracts with the same buffer level and term length, but with a new upside cap. This cap
may be higher or lower than the preceding period and will depend on options market conditions at that time.

This structure has four important implications:

First, exposure to the index is limited to price returns (dividends are not included).
Second, downside protection is only “buffered,” not eliminated. When the referenced index falls below the downside buffer, the fund will resume participating in losses as a result of the put sold in layer three. In other words, if the index declines 27% during the outcome period and the fund has a 10% buffer, an investor will experience a roughly 17% loss (management fees will subtract slightly more).
Third, the fund’s upside is capped through the sale of the call option at whatever level generates sufficient additional income to offset the purchase of the put in layer two. Consequently, if investors want more downside protection, the trade-off is a lower upside cap. Conversely, for less downside protection, investors retain more upside potential.
Finally, the strategies employed by buffer ETFs will generally cause these funds to exhibit greater potential for loss than potential for gain. In other words, by capping the upside, investors miss out on gains that exceed the upside cap, but they still participate in all downside losses minus the buffer.

Despite buffer ETFs’ growing popularity, investors shouldn’t ignore the impact that excluding dividends
and capping performance will have on their overall experience. As a rule of thumb, when markets are more
volatile investors typically can receive better terms, as volatility is a component of options pricing. However,
the cost of the FLEX options held by these types of ETFs may not be well disclosed to investors, and rolling
options (replacing expiring options with new options) may cause the performance of buffer ETFs to lag significantly
compared to ETFs that directly hold the stocks in the underlying indexes.

Bottom line

During their relatively brief history, buffer ETFs have worked as expected—even during the extreme volatility of
early 2020. Although they did not eliminate losses during those periods, they buffered them. The ETF wrapping also
provides some benefits versus other structured products, such as greater transparency and liquidity.

However, buffer ETFs aren’t right for everyone. Investors seeking downside protection should explore all their
financial options before making a decision. These options may include adjusting your asset allocation to
better match your risk tolerance, or exploring the role that annuities and insurance may play in your overall
financial portfolio.

¹Based on data from FactSet, June 22, 2022.

Important Disclosures:

Investors should consider carefully information contained in the prospectus or, if
available, the summary prospectus, including investment objectives, risks, charges,
and expenses. Please read it carefully before investing.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Please read the options disclosure document titled “Characteristics and Risks of Standardized Options.” Supporting documentation for any claims or statistical information is available upon request.

Investing involves risks, including loss of principal. Hedging and protective strategies generally involve additional costs and do not assure a profit or guarantee against loss. Multiple leg options strategies will involve multiple commissions. Covered calls provide downside protection only to the extent of the premium received and limit upside potential to the strike price plus premium received.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Asset allocation strategies do not ensure a profit and do not protect against a loss in any given market environment.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

What are Buffer ETFs?

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