Exchange Traded Funds (ETFs) are nothing new. First listed in 1993, passive funds now account for over 41% of combined U.S. MF and ETF assets under management (AUM), up from 3% in 1995 and 14% in 2005. 
Yet despite significant proliferation, it could be argued that that there hasn’t been a whole lot of product innovation in the ETF marketplace until recently –
Introducing “buffered,” or, “defined-outcome” ETFs.
The brainchild of industry pioneer Bruce Bond, defined outcome ETFs seek to moderate an investment’s return potential over a given time period. Using derivatives, buffered ETFs can track broad market indexes or even other ETFs, offering a variety of downside and upside profiles.
Buffered ETFs come in all shapes and sizes, but share a few common traits: 
- Track the price returns of a specific index
- Seek to provide a level of downside protection
- Participate in upside returns up to a stated cap
- Have a maturity date at a specific point in the future, normally 12 months
With around $5bn in total AUM , buffered ETFs allow investors to participate in the growth potential of risk markets up to a stated cap, all the while providing an explicit downside buffer in case things take a turn for the worst. This value proposition is attractive to risk-averse investors who would happily forego upside potential in return for protection on the downside.
How does the ETF use Options?
Unlike traditional ETFs, defined-outcome ETFs don’t actually own any shares. Instead, they rely on derivatives to “define” their return pattern over a stated time period – often 1 year.
More precisely, buffered ETFs hold a basket of flexible exchange, or “FLEX” options, chosen with strike prices that expire on a stated outcome period end date. These options give the buyer the right, but not the obligation, to buy or sell the underlying index at a set price at a future point in time.
FLEX options are more customisable than their traditional cousins but similarly benefit from no counterparty risk as they trade on options exchanges backed by the Options Clearing Corporation (OCC) which acts as a guarantor and central counterparty.
According to Innovator there are 3 main steps in creating a buffered ETF: 
The first task involves buying and selling derivatives to provide synthetic exposure to a reference index for a future maturity date, normally 12 months ahead. Just like normal ETFs, defined outcome ETFs can track any number of assets.
The second step is building the downside buffer. To do this, the ETF incorporates a put spread for the outcome period which corresponds with the stated buffer level.
The final step involves selling a call option which caps the return of the ETF compared to the reference index.
Importantly, increasing the downside protection comes at a cost – the greater the buffer, the less upside potential.
Ok, So what does this mean in practice?
Imagine 4 scenarios:
- Great Market (15% Annual Growth)
- Good Market (6% Annual Growth)
- Bad Market (-4% Annual Growth)
- Terrible Market (-20% Annual Growth)
You purchase the buffered ETF at issue, set to track a market index, with a stated downside buffer of 10% and an upside cap of 9%. It has a 12-month maturity, and you hold till completion.
In scenario 1, your investment would rise with the reference market index until it achieved a 9% growth rate. It would raise no further, capped at 9%.
In scenario 2, your investment would rise with the reference market index until it achieved a 6% growth rate. It could rise further, however will never outperform the market index.
In scenario 3, whilst the market index fell 4%, your buffered ETF would fall 0%. This is because the 4% loss is captured entirely within the stated 10% buffer.
In scenario 4, whilst the market index fell 20%, your buffered ETF would only fall 10%. This is because the 10% of the loss is captured within the stated 10% buffer.
This logic applies for any level of buffer and cap and can be illustrated by the following payoff diagram:
Timing is Key
Timing is important when purchasing a buffered ETF, as it can impact the level of upside and downside potential provided at a given moment. Stated cap and buffer levels only apply at launch date prices and are set to change as ETFs trade throughout the outcome period and open market conditions influence price movements.
Investors can hold the ETF past the maturity date, whereby the product will simply rollover and the cap and buffer will reset. Whilst the buffer will remain the same, new cap levels may be higher or lower than the preceding period depending on options market conditions at the time of reset.
Why use it? Where does it fit?
As markets become more globally integrated, volatility has become more of a concern in any portfolio. Unprecedented market uncertainty during 2020 has shifted the mindset of many investors towards managing risk, and the growing worry that markets may be overstretched in 2021 has led to many seeking downside protections.
Buffered ETFs can be used by investors looking to reduce volatility whilst staying invested in risk markets, such as the millions of Baby Boomers close to retirement. Those seeking to move cash off the side-lines but turned off by low-to-negative bond yields can also use buffered ETFs to increase their equity market exposure whilst maintaining a degree of safety of funds.
The Small Print – are they ETFs at all?
Investors should be aware that buffered ETFs are so far only available in the US, and the majority track equity market indices only. Buffered ETF investors also do not receive dividend payments.
Furthermore, fees are also higher than regular passive funds, typically at around 0.8% compared to 0.4-0.55% for equity ETFs. That said, buffered ETF fees are significantly lower than the average annual fee of 1.42%charged by US mutual funds.
Lastly, questions have been raised about whether buffered ETFs deserve their ETF title at all. Critics have warned that too many complex products are being branded as ETFs when they really should be called exchange traded instruments or products (ETIs/ETPs).
In a letter to Cboe Global Markets, major ETF providers have lobbied to strip certain funds of their designation as ETFs, maintaining that “investors (need to) understand that certain ETPs have a greater embedded market and structural risks and more complexity than others.” 
After a blockbuster 2020, the pressure to redesignate buffered ETFs as ETPs could slow further growth in AUM as investors could be put off buying products with unfamiliar sounding names.
That said, regardless of their title buffered strategies will remain an intriguing proposition in today’s markets as long as investors flock towards greater certainty.
Final Year Undergraduate Student at the University of St Andrews, Studying Finance