Buffered ETFs protect against market drops. They are selling like hotcakes.

Buffered exchange-traded funds protect you against stock market losses, but you have to give up part of your upside in return.

The ETFs are selling strongly so far this year with the S&P 500 down about 9.8% on a total return basis. They appeal to retirees and other conservative investors.

According to FactSet, investors have sent nearly $7 billion into buffered ETFs as of early April. Also known as structured outcome or defined outcome ETFs, there are about 400 of these investment vehicles holding nearly $70 billion.

The products use options to buffer against stock market losses, anywhere from the first 10% to 100% downside protection, depending on the specific ETF strategy. They tend to have higher annual fees than most ETFs.

How They Work

The genesis of these ETFs was to keep investors in the market during normal pullbacks, says Lois Gregson, senior ETF analyst at FactSet.

Buffered ETFs put guardrails on an investor’s return, using options to limit losses in exchange for capping gains. Generally, these strategies will buy put options against an index, which is the right to sell an asset at a certain price. To pay for the options, the strategy sells call options, the right to buy an asset, at certain levels above the market, limiting the upside. Typically, investors only receive the price return of the ETF, not any dividend.

The deeper the buffer, the tighter the upside cap. The $906 million FT Vest U.S. Equity Buffer February ETF provides a buffer against the first 10% of market losses and will match the S&P 500’s price return up until 14.5%, minus fees and expenses. The $48 million FT Vest U.S. Equity Max Buffer February buffers against 100% of losses, but limits gains to 7.12%.

For ETFs with a 10% buffer, if the market is down, say, 5% at the end of the outcome period, the ETF won’t have losses. If the market is down 15%, the ETF will be down 5%. If the market’s return at the end of the outcome period is above the ETF’s cap, the investor misses out on those gains.

These strategies allow investors exposure to equity growth, but without the full risk exposure, says Michael Loukas, CEO of TrueMark Investments, the firm behind the family of TrueShares ETFs.

“The point is, it gives these investors a much more enjoyable ride when they still need some growth. So they’re willing to make that trade off of ‘I’ll take a little bit less growth if you can give me more downside protection or volatility management,’" he says.

Curtis Congdon, president of XML Financial Group, says he uses these ETFs for retirees or those approaching retirement and don’t need current income. He says his retired clients generally don’t mind if the ETFs’ return lags behind the broader market’s gains.

“If the market’s up 20% and a retired client is up 15%, very rarely will they be upset that they didn’t have all of the upside participation," he says, adding that he uses these as part of a broader, diversified portfolio, not as someone’s only holding.

Fund Nuances

Although the ETFs are tradable, to receive the exact buffer and cap as marketed, investors must own them for the full outcome period. Typically the funds have a 12-month outcome period, such as Jan. 1 to Dec. 31, and many issuers launch new ones monthly.

Investors can buy and hold these ETFs, and the buffer resets based on whatever the market is trading at after the defined outcome period ends. So a 12-month ETF with a 10% buffer that ends on Dec. 31 will reset on Jan. 1.

Investors who don’t buy an ETF on the first day of the defined investment period will need to refer to the fund issuer’s website to understand potential outcome parameters. That’s critical because if someone buys one of these ETFs in a down market, they may not have the full downside protection as marketed.

The net asset value of the fund will vary with the price of the underlying options position until it comes closer to the end of the outcome period, when the options contracts expire.

Loukas says many investors don’t understand that these ETFs can fluctuate during the outcome period. “You won’t realize that full buffer until the tail end of that investment period," he says.

Compared with plain-vanilla stock index ETFs, these are costly, says Nate Geraci, investment advisor and president of The ETF Store. The most expensive cost 0.95% annually, and some of the cheaper ones cost 0.5%. The average S&P 500 fund cost under 0.10%.

With a higher cost and no dividend payments, investors in buffered ETFs can lose money in a flat market, Geraci says.

These products are best suited for investors who make emotional decisions when markets swing, he says. Investors who can ride out volatile markets may be better off holding a diversified portfolio.

“You have different variations of buffer ETFs on the market, and you have to compare those to what an investor would receive if they were in a diversified portfolio of stocks and bonds," he says.

However, FactSet’s Gregson says for investors who otherwise use annuities or structured notes to reduce risk, these ETFs are cheaper, more transparent and flexible. These ETFs are also cheaper, more tax efficient and convenient than buying individual options to hedge equity risk.

Write to editors@barrons.com