Investors worried about the US presidential election may turn to a burgeoning sector of the ETF market to ease fears and protect their money from stock price fluctuations. Watching over event-driven volatility is one use case for option-based funds, which have become increasingly popular among investors since the COVID-19 pandemic. Often called “buffer funds,” these ETFs use options to offer investors protection from downside risk in exchange for giving up potential upside. In a June report on the ETF industry, JPMorgan said the category currently has about $40 billion in assets under management. Funds come in a variety of time frames, with new funds launched and reset every month, so there are a few options for investors to buy now and protect themselves until the November election. “If you watched the debate, [Thursday] “If you’re having a night like everybody else and you’re like, oh, what’s going on with our country, I’m not sure how I feel about the election, buy a six-month thing,” said Bruce Bond, CEO of Innovator Capital Management, one of the companies that developed this type of ETF. How it works These downside protection ETFs are created by combining different derivative contracts on market indexes, such as the S&P 500, with flex options. One way to structure these funds is to essentially buy deep-in-the-money call options, allowing the trade to capture a market upswing, and then create what’s called a put spread to create a downside protection layer. A call option gives the holder the right to buy the underlying asset at a certain strike price, while a put gives the holder the right to sell. The third step is to sell another call option above the current market level. This funds the rest of the trade and creates the upside cap. Every fund has a reset date, which usually ranges from one quarter to two years. These funds are designed to be held for the entire period to get a stated outcome, and if you sell the fund before the reset date, you may not get the full benefit of the upside due to the nature of option pricing. “They can use structured protection funds, which essentially allow them to dampen volatility through the election cycle without sacrificing all of the upside opportunity in equities,” said Matt Kaufman, head of ETFs at Calamos Investments, one of the firms launching the new fund on Monday. Many ETFs offer downside protection in the 10% to 30% range and are often called buffer funds. Other products that offer 100% downside protection (in exchange for smaller upside) are sometimes marketed as “principal protection funds.” Jim Saulnier, CFP, founder of Jim Saulnier & Associates in Fort Collins, Colorado, said his clients use both buffer funds and 100% downside protection funds. His firm has about $140 million in assets and serves mostly retirees.Saulnier said clients are putting money into these funds that they plan to spend years from now. The buffer keeps clients from making rash moves when markets fall, and allows them to diversify their portfolios in a way that bonds haven’t done in recent years, he said. “A lot of clients have been very surprised by the bond selloff and are concerned about what will happen if inflation comes back and the Fed has to continue raising interest rates. They don’t want to see an investment that was meant to have some degree of zero correlation with stocks go back to a near perfect correlation,” Saulnier said. As the category has gained popularity, the number of companies launching these funds has grown and so have their variations, giving investors more options. Several funds launched Monday, including products from iShares, Calamos and Innovator, that track different indexes and time frames. “This product category has really exploded,” Bond said.Volatility Outlook Market volatility has been muted over the past year, but Cboe volatility index futures indicate traders expect at least some activity around the election. “When you have a known event like this, there’s always some premium for protection,” said Matt Thompson, a portfolio manager at Little Harbor Advisors. Little Harbor specializes in building volatility strategies for clients, but Thompson said it’s too early to start hedging your portfolio. Of course, other ways investors can protect their assets during the election are short-term Treasury bills and bank fixed deposits, which can still earn returns of more than 5% per year. But ETF issuers point out that if they go the bond route, investors could end up paying ordinary income taxes next year, as opposed to holding the ETF’s capital gains proceeds until they decide to sell. “When you compound that, the compounding growth inside a tax-deferred ETF wrapper makes a huge difference,” Kaufman said.Correction: The iShares Large Cap Max Buffer Jun ETF has an upside cap of 11.1% before fees. An earlier version of this article incorrectly stated this figure.
Fast-growing buffer funds could help investors hedge election risk
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