Podcast: A Deep Dive on Buffer ETFs

In this deep-dive episode, Portfolio manager Chris McHaney, and your host, McKenzie Box, delve into Buffer ETFs — starting with the fundamentals, including how they work and where they fit into portfolios. They also provide comprehensive scenarios for various market conditions. 

McKenzie Box is Director of Product and Strategy at BMO Global Asset Management. She is joined on the podcast by Chris McHaney, a Portfolio Manager and ETF Specialist at BMO Global Asset Management. The episode was recorded live on Wednesday, February 7, 2024.

Visit the BMO ETF Centre

What are Buffer ETFs?

Buffer ETFs are a recent innovation in the ETF space that provide investors equity market exposure and growth potential. They also use an option overlay to create a built-in protection against downside risk in the equity market. Essentially, it creates a smoother return path for conservative investors that still want equity exposure. BMO ETFs has a long history of innovation with option overlays. We were the first to offer covered call ETFs in Canada, which add an additional income stream that investors love. In the case of buffer ETFs, we’re adding downside protection for more conservative investors or investors that are a bit more bearish on the market. We want to continue to expand the offerings available to investors.

How do Buffer ETFs fit into a portfolio?

Buffer ETFs could take a portion of an investor’s equity market exposure. How much to allocate depends on the investor’s risk tolerance, growth needs, and market outlook. Fixed income has played a traditional role as a hedge against equity exposure. Investors who experienced one of the worst years (2022) for balanced funds, may want to look at a different way to maintain equity exposure, but have a more explicit hedge.

How do Buffer ETFs work?

There are similarities between buffer ETFs and covered call strategies. Imagine starting with exposure to the S&P 500 Hedged to CAD and adding an option overlay to create downside protection. What’s unique about buffer ETFs versus covered call ETFs is that protection is put in place during the target outcome period, typically one year. After inception, if the market moves up investors will have less upside potential because they’ll be getting closer to the cap, but they’ll have more downside protection. Conversely, if the market sells off investors will have less buffer protection, but they will have more upside potential because the cap will be further away. Every day, the risk/​return trade-off that a buffer ETF provides is essentially known in advance, if the investor holds it until the end of the outcome period, when the options expire. If you are interested in purchasing a buffer ETF, you can look on our website (Daily Metrics) for our daily Buffer metrics. 

After the one-year period is up and the option positions mature, a new protection level will be set. It is essentially a new target outcome period. Investors can simply hold on to the ETF while a new protection level and cap is put in place, so investors can continue to grow their investment over time.

Scenarios

One scenario can be an investor buys BMO US Equity Buffer Hedged to CAD ETF - January (Ticker: ZJAN) on day one of the outcome period, and they hold it for the entire one-year period until next January. Let’s assume the market is down significantly, -20%. In that environment, the buffer ETF provides protection against the first 15% of losses. Now, let’s assume there’s a mild sell-off; perhaps the market sells off 10%. The buffer ETF should be close to flat over the one-year target outcome period. In a more positive scenario where the market is slightly up, let’s say 5-6%, the beauty of the buffer ETF is that it will fully participate in that growth potential on a one-to-one basis. Finally, if markets are up significantly, 12-20%, the Buffer ETF will lag since it will only participate up to the cap level at that time. It is important to also mention that all these return scenarios are based on the price return of the underlying investment, and investors will collect dividends on top of that. Also, the outcomes in any scenario are always before management fees, taxes, and expenses.

Future Launches

BMO GAM has already filed to launch the same strategy that will reset in April and July. So, eventually, BMO ETFs will offer four different Buffer ETFs providing the same 15% downside protection against the S&P 500 Hedged to CAD Index. Every three months, investors will have the choice to participate in a new outcome period or potentially stay in one that they’re already in. Again, we will have up to four of them to choose from that will have slightly different risk and return profiles based on where their protection levels and cap levels were set.