Before investing in buffer ETFs, it's important to understand how they can help mitigate losses.

• ETFs with defined outcomes, also known as buffer exchange-traded funds, employ options contracts to restrict losses and limit upside potential.
• The number of buffer ETFs increased from 73 to 327 between August 2020 and August 2024, resulting in a significant increase in assets from $4.6 billion to $54.8 billion, as per Morningstar Direct's data.
• Experts claim that buffer ETFs are more complex and expensive than traditional ETFs.

Experts advise that if you're looking for protection from market fluctuations, buffer exchange-traded funds can help mitigate downside risks. However, these ETFs also limit potential gains and come with higher fees.

ETFs that provide a pre-determined range of outcomes over a set period are called buffer ETFs, also known as defined-outcome ETFs. These funds are linked to an underlying index, such as the S&P 500.

Over the past five years, these funds have been one of the fastest-growing areas of the ETF market, with demand surging in 2022 as investors faced correlating losses from stocks and bonds, according to Bryan Armour, director of passive strategies research for North America at Morningstar.

In August 2024, the number of buffer ETFs increased to 327, with a total asset value of $54.8 billion, compared to 73 ETFs and $4.6 billion in August 2020, as per Morningstar Direct's data.

The funds create a 'buffer zone'

The "outcome period" of buffer ETFs applies only if investors hold the fund for a specified time frame, usually one year.

Armour stated that during the outcome period, the funds have a "buffer zone" that safeguards investors from some losses and restricts returns above a specific limit.

When investing in a buffer ETF, you may experience a shield against the first 10% of losses, but your upside potential will be limited to 15%. However, if you buy midway through the outcome period, you may not receive full exposure to the upside.

Similarly, selling before the outcome period ends could limit downside protection.

Armour stated that individuals should be cautious when buying and selling during that period, as they may not be receiving what they believe they are purchasing.

Over the past 20 years, the S&P 500 has seen annual returns of up to 2.2% due to dividends, but plus-buffer ETF investors typically do not receive these dividends.

The average buffer ETF has a higher fee of 0.8% compared to the average traditional ETF's fee of 0.51%, according to Armour.

The biggest drawback of investing in stocks is "opportunity cost," according to him, which depends on your alternative investment options.

The benefits of buffer ETFs

Experts suggest that buffer ETFs may be appealing to more conservative investors, provided their investment objectives, risk tolerance, and time horizon align.

David Haas, president of Cereus Financial Advisors in Franklin Lakes, New Jersey, stated that he has been utilizing buffered ETFs in client portfolios for a while and really enjoys them.

Buffer ETFs provide immediate liquidity if you need access to cash, in addition to downside protection and market exposure, he stated.

ETFs are ideal for investors with low risk tolerance and a shorter timeline, as long as they comprehend the asset's functioning, according to Armour.