Buffer ETFs: How They Work and What the Cap Costs You

A buffer ETF absorbs the first slice of an index decline for you. Usually the first 9%, 15% or 20%, over a set period. In exchange you accept a cap on the upside. That trade is the whole product.

The most common mistake is treating the cap as a limitation the issuer chose to impose. It is not a design preference. The cap is what paid for the protection. Once you see the transaction that way, every confusing thing about these funds becomes predictable. Why caps differ between funds. Why they move when interest rates move. Why the fund you bought in March does not carry the cap printed on the website. And why your month-four statement will not show the buffer you were promised.

What is a buffer ETF?

A buffer ETF uses options to deliver a stated range of outcomes over a stated period. You get index upside to a cap. You get index losses only beyond the buffer.

These are also called defined outcome funds, and the two terms describe the same thing. Defined outcome is the more accurate name. What the fund defines is a range of results over a stated period, not a floor you own at all times.

How does a buffer ETF actually work?

A buffer ETF is built from FLEX options on an ETF that tracks the index. Whether it also owns that ETF directly varies by fund and by outcome period, and that choice decides whether you receive dividends. Check the prospectus for the fund you are buying rather than assuming.

Either way, the fund first has to own the upside before it can shape it. That comes from a long call struck near today’s level, or from holding the underlying ETF outright. Every other leg is built on top of that position.

Burke Ashenden, Head of Capital Markets at Innovator, walked through the legs on Behind the Ticker. Start with the protection: "we buy an at the money put and that gives us that full protection." An at-the-money put pays off dollar for dollar as the index falls below today’s level.

That put is expensive, and the fund has to pay for it somehow. Which is where the cap arrives: "So that’s the third option leg. We’re going to sell a call at the highest level that we" "can to finance that protection. And whenever we strike that call, that’s the cap on the ETF."

Read that sequence again, because it is the whole product. The fund buys downside mitigation, and selling upside is how it pays for it. The strike of the call it sells becomes your cap, which makes the cap a receipt.

Johan Grahn of Allianz described the buffer itself as a put spread, which is the other half of the picture. You buy a put at the money and sell one out of the money at 10% or 20%. That sold put is why the protection ends where it ends. Below the buffer level, you are exposed again.

All of this is done with FLEX options rather than the listed contracts you would find on an exchange screen. Ashenden explained why: "Flex, you can just think of flexible. You can customize the tenor, you can customize the strike," and the fund needs that because "we want to deliver that exact buffer that we state." A 15% buffer expiring on a specific date does not exist as a listed contract, so it has to be built.

What does the buffer ETF math look like?

Ashenden gave the numbers plainly. With a 15% buffer: "If the market’s down 20% and a 15% buffer, you’re going to be down 5%. If the market’s down 10% and" "you have a 15% buffer, you’re going to be flat. Less expenses, obviously."

So the buffer absorbs the first fifteen points of decline. Beyond that you take losses one for one alongside the index. Most people arrive at a buffer fund already understanding this half.

The upside is where a detail hides. Ashenden: "You’re one-to-one on the upside with the price return of SPY to that cap."

Price return, not total return. A fund holding FLEX options only does not own the underlying, so it does not receive the dividends. Funds that hold the ETF directly calculate the outcome using an assumed dividend rate instead. On a broad US index that yield is currently around one percent a year. Small but real, and it never appears as a fee.

Mike Loukas of TrueShares put the trade in one sentence. Investors are "willing to give up some of that upside potential, right, for downside mitigation." That is an accurate description of the bargain. It is worth knowing exactly what the "some" consists of.

A worked example: a 15% buffer across 2022 and 2023

Use two real calendar years and one hypothetical fund. The arithmetic below is illustrative, not the record of any actual fund.

The S&P 500 price index closed 2021 at 4,766.18. It closed 2022 at 3,839.50. That is a fall of about 19.4% over the year.

Take a 15% buffer with a 12-month outcome period starting on the first trading day of 2022. The index fell 19.4%. The buffer absorbs the first 15 points. You finish down roughly 4.4% before expenses, against an index investor down 19.4%. About fifteen points of difference, which is exactly what the structure was built to do.

Notice what did not matter in 2022. The cap. The market never came near it, so the price was never collected. That is why these look free in a bad year.

Now run 2023. The index closed that year at 4,769.83, up about 24.2% on price. Suppose your cap had been struck at 16%. You earn 16% and the index earns 24.2%. Roughly eight points left on the table.

That is the receipt. Two years, one structure, and the bill arrived in the second one. An advisor who shows a client only the 2022 column is selling the product, not explaining it.

Why do buffer ETF caps differ so much?

If the cap is what pays for the protection, then the cap is set by how much the protection costs on the day the fund resets. Two things drive that.

The first is volatility. Options are priced off expected movement. When markets are jumpy, the put the fund needs is expensive and the call it sells has to be struck lower to raise the money. High volatility produces a low cap.

The second is interest rates, which is less intuitive and matters more than most people expect. Matt Kaufman of Calamos, discussing the arrival of fully protected structures, noted that the product "really couldn’t have been developed when rates were, you know, below one, two percent."

Kaufman also gave the arithmetic behind a protected structure, and it makes the rate dependence concrete. The fund spends "about $96 on those zero coupon bonds, and that gives us about $4 or 4% to" spend on the option package. When rates are high, a bond maturing at 100 in a year costs 96, leaving four points of budget. When rates are near zero, that same bond costs 99, and the budget collapses to almost nothing.

So a cap is a snapshot of market conditions on a reset date. Comparing the caps on two funds tells you as much about when each one reset as about which issuer is better at this.

Where can I find a list of buffer ETFs?

There is no single official list, and any list you find goes stale fast. New outcome periods launch every month.

Go to the issuers directly. The largest sponsors in the category include Innovator, First Trust, Calamos, AllianzIM, PGIM and TrueShares. Each one publishes a daily table for every fund it runs.

That table is the document that matters, not a third-party roundup. It carries the starting cap and buffer. The remaining cap and buffer as of today. The reset date and the reference index.

Screen on outcome period and reference index first, then buffer level. Sorting by cap alone just hands you whichever fund reset on the most favorable day.

What do people get wrong about buffer ETFs?

Buying mid-period. The cap and buffer printed in a fund’s marketing apply to an investor who bought on the reset date and holds to the end of the outcome period. Buy in month five and your numbers are different, because the index has moved since then.

Ashenden was precise about the direction: "The cap is the cap. But if the market does move down negatively, you’re just going to have more cap." If the index has fallen since the reset, you are buying in below the cap’s strike, so you have more room to run. You have also used up some of the buffer, since part of the protection has already been consumed by the decline that happened before you arrived. Every issuer publishes the remaining cap and remaining buffer daily. Look them up rather than reading the brochure.

The mid-period statement. This is the one that generates client phone calls. Loukas described it better than anyone else in the archive: "with the annualized product or even the six-month products, you have an extended period of time where your expected return doesn’t necessarily match up with your current price or current value of the investment because the options decay, because of the length of those options."

The options in the fund have not expired yet. Their value in month four reflects time remaining, volatility and the level of the index, not the payoff diagram. So a fund with a 15% buffer can show a loss in a market that is down 8%, even though the stated outcome at the end of the period would be no loss at all. Nothing has broken. The outcome is defined at expiry and only at expiry.

That is the single most important sentence to say to a client before they buy one.

When buffer ETFs do not work

Five situations, and every one of them is foreseeable.

• The decline runs deeper than the buffer. From 19 February 2020 to 23 March 2020 the S&P 500 fell about 34%. A 15% buffer would have left you down around 19%. Real help, and still a bad month.
• The market runs hard. A capped position in a year like 2023 gives up real money. The cap costs nothing in a down year and a lot in a strong one.
• You need the money mid-period. Sell before the reset and you get the option math, not the payoff diagram. The defined outcome is defined at expiry.
• Rates fall. A low-rate world shrinks the option budget, so caps get worse at exactly the moment the funds look most appealing.
• You wanted total return. Where the fund holds options only, the dividend stream is not yours. Around one percent a year on a broad US index, compounding against you.

None of that makes these bad funds. It makes them instruments with a shape, and the shape has to match the job.

How do advisors use buffer ETFs?

Loukas described how allocators actually use them, and it is more mechanical than the brochures suggest. "if you’ve got a 12-month buffered ETF strategy where you’re layering or laddering 12-month buffered ETFs," you hold several with staggered reset dates. That smooths the calendar risk of any single outcome period. It also means you always have one approaching reset rather than being locked to one date chosen by accident.

The category grew because it replaced structured notes. Same payoff shape, but with daily liquidity, no issuer credit exposure and a published price. The payoff is old. The wrapper is what is new.

Buffer ETF terms, defined

• Buffer ETF. An ETF using options to absorb a stated slice of index decline, in exchange for a cap on gains.
• Defined outcome fund. Another name for the same thing.
• Buffer. The first portion of index decline the fund absorbs, commonly 9%, 15% or 20%.
• Cap. The maximum return you can earn over the outcome period.
• Outcome period. The window the cap and buffer apply to, most often twelve months.
• Reset date. The day the fund strikes a new cap and buffer for the next period.
• Remaining cap and remaining buffer. Today’s figures for someone buying mid-period, published daily by the issuer.
• FLEX options. Exchange-listed options with customizable strike and expiry, cleared by the OCC.

The checklist before you buy one

Which index, what buffer, what cap, what outcome period. Then the remaining cap and remaining buffer as of today. Then the reset date.

And one expectation to set out loud, in advance. The statement between now and the reset will not match the payoff diagram. That is the structure working as designed.

This is educational content and not investment advice. It is not a recommendation regarding any security. Investing involves risk, including possible loss of principal. Past performance is not indicative of future results.