Buffer exchange-traded funds have proliferated in the past few years as investors have sought safety following 2022’s market downturn. However, Morningstar analysts see only a narrow use case for these funds, especially when there are cheaper alternatives.
Buffer ETFs, also known as defined outcome ETFs, use options to limit the losses on a portfolio over a set period in exchange for limiting gains. Buffer ETFs have grown to nearly $50 billion in assets from just over $5 billion at the end of 2020. While 10 brands have entered the space, including the titanic iShares, two are dominant: Innovator and First Trust.
These funds may be useful for investors with extremely low risk tolerance, or those who have a very short time horizon for their investments. But Morningstar manager research analyst Zachary Evens says other investors may want to steer clear. Among other things, fees on buffer funds are typically on the high side. “There is a genuine use case, albeit a relatively narrow one, and if you’re looking for risk-managed equity exposure, you can achieve that for a far lower cost,” he says.
How Do Buffer ETFs Work?
A buffer ETF holds a stock portfolio and buys put options—the rights to sell an asset at particular prices—at the current price. This means the manager of the portfolio can sell the stocks at the starting price even if they fall, preventing losses. To pay for these options, the funds also sell call options—the rights to buy assets—at a certain level above current stock prices. This limits the upside because if the stocks go higher, the investor who bought the call options would buy them for that lower price.
Options contracts only last a limited time, meaning buffer ETFs are meant to be purchased and then sold at a particular date. If investors buy late or sell early, their returns won’t necessarily be within the same range.
Take the $0.9 billion FT Vest US Equity Buffer ETF – January FJAN. If an investor purchased it on Jan. 21, 2025, it would protect against the first 10% of losses on a stock portfolio over the next year while capping gains at 14.2%. So if, at the end of the year, the SPDR S&P 500 ETF Trust SPY (the stock portfolio on which the buffer ETF is based) is up by 20%, the buffer ETF would be up 14.2%, while if the fund is down by 15%, the buffer ETF would be down by 5%.
Since these ETFs are meant to be bought and sold at the start and end of a certain period (usually a year), firms will often have 12 different funds for each buffer strategy—one for each month. This makes for a quirk in tracking the buffer ETFs on the market. While there are 363 funds in Morningstar’s Defined Outcome ETF category, there are considerably fewer unique strategies underlying that number.
There are two major events in the rise of buffer ETFs. The first is a 2019 regulatory change by the SEC that made it far easier for firms to launch active ETFs. Buffer funds fall under the actively managed umbrella. The other was the down market of 2022, in which stocks and bonds dropped in tandem.
“2022 was kind of the perfect storm for these to take hold for investors and their advisors to take notice of these products,” says Evens. “Investors were surprised when their bond portfolio also dropped a considerable amount next to their equity portfolio, which may have dropped 20 or more percentage points on that year.”
Innovator and First Trust have virtually complete dominance of the buffer ETF market. As of the end of 2024, the funds run by the two firms had $42 billion of the category’s $48 billion in assets. Larger fund companies, including BlackRock’s iShares, have launched buffer funds in the category, none of which have yet received much traction.
When Buffer Funds Do and Don’t Make Sense
Evens sees two main reasons to consider buffer ETFs. First, an investor may have a short time horizon. “For people who may be close to retirement, and their financial advisors are making plans for them and projecting into the future, it’s really easy to have those set limits,” he says. “People considering a large one-time purchase like a house need their money in two or three years, and you don’t want to risk a 50% drop in the S&P 500.”
Buffer ETFs may also work well for investors who are extremely intolerant of risk. “These are people who are 45 years old, and their advisors are urging them to invest in stocks, but they don’t want to. They might see buffer ETFs as a way to get some sort of stock exposure,” Evens explains. “Some equity exposure is better than none.”
But while they have legitimate uses, Evens says buffer ETFs are likely not the best option for most investors. First, the upside cap on buffer ETFs will cost investors over the long term, with losses prevented not making up for lost gains. “Looking at rolling returns of the S&P 500, it’s not news to say it skews positive,” he says.
Second, buffer ETFs usually carry very high fees. The largest one, the $6.3 billion FT Vest Laddered Buffer ETF BUFR, has a net expense ratio of 0.95%, and even cheaper funds in the category still have expense ratios of 0.5%. This means investors in buffer ETFs—even those with full downside protection—can end the year down the better part of a percentage point after fees.
For investors who are not looking for a defined outcome for any individual year and just want to manage the risk of their portfolio, there are usually far cheaper options. “If you’re looking for a particular beta [a level of portfolio volatility], you can achieve much more risk mitigation through just effectively allocating between cheap stock and bond index ETFs. Buffer ETFs are more of a ‘peace of mind’ allocation,” explains Evens. “However, I think [buffer ETFs] are more of a peace of mind allocation, and I don’t know if people are kind of doing the math and looking at inter-period volatility on these.”