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How a Buffer Fund of Funds Can Help Advisors Manage Risk
Commentary September 20, 2022 at 08:25 PM Share & Print
Among many other market participants and experts, former Federal Reserve Bank of New York President Bill Dudley warned that stock and bond investors should batten down the hatches as steps are taken to get inflation under control.
Market drops could become more pronounced , and advisors should understand all the risk-mitigation investments available to them. Since that warning in early April, we have seen markets continue to struggle, with the S&P 500 and Nasdaq Composite down -19.6% and -27.8% respectively year to date.
Buffer funds, which include exchange-traded funds, mutual funds and unit investment trusts, have emerged as standout options for advisors and investors looking to manage market volatility. Over the past few months, buffer ETFs have become particularly prominent with advisors. These funds are liquid, transparent, customizable based on investor risk tolerance, and have lower fees than index annuities and structured products do.
There are drawbacks, however, associated with buffer ETFs — primarily monitoring where the ETFs trade in relation to their upside caps and the associated capital gains taxes that come with selling an individual buffer ETF before the end of its outcome period. Given the nature of these investment vehicles, each buffered ETF has a cap that limits the upside over a specified outcome period.
Advisors seeking to maximize returns while minimizing risk may decide to sell individual buffer ETFs when they’re trading near their upside cap before the end of the outcome period. This process is time-consuming and can generate capital gains taxes, which eat into returns that are capped. But actively managed fund-of-fund (FOF) buffer products can help address these shortcomings head-on while offering advisors added benefits.
FOFs might not be a new concept to those in the mutual fund and hedge fund industries. To those who are unfamiliar, this investment strategy means exactly what it implies. In the context of this article, it is one ETF product that spreads out assets across a series of buffer ETFs. Buffer FOFs aim to offer more diversity, tax efficiency and ease of use, while hopefully reducing the advisor time commitment required to invest in these innovative strategies.
A FOF provides exposure to numerous buffer ETF products in one ETF wrapper. This approach offers advisors an opportunity to selectively own a diversified basket of individual buffer ETFs that have attractive risk-reward profiles in the current market environment.
Individual buffer ETFs will often go through periods of time when the product is trading near its upside cap prior to the end of the outcome period. This presents the advisor with the difficult decision of whether they should sell the individual ETF to lock in gains or hold on until the end of the outcome period.
Using a FOF approach, advisors aren’t limited to one particular buffered note and don’t have to settle for an ETF that could be pressing up against its cap, inhibiting potential gains. A FOF offers advisors access to a basket of buffered notes with various caps that could potentially position a portfolio to achieve gains it otherwise would’ve missed out on, especially because these are actively managed by the fund sub-advisor to help with the rollover of funds.
By analyzing where each buffer ETF is trading relative to its upside cap and the broader market, there are periods of time where certain buffered ETF series might offer better risk-reward profiles than others. The FOF is able to analyze where each individual buffered ETF is trading relative to its cap and outcome period and opportunistically weight the portfolio by allocating to individual buffered notes that currently have the most attractive risk-reward profiles.
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For example, if an individual buffered ETF is pressing up against its cap before the end of the outcome period, the FOF portfolio manager could potentially rebalance out of that individual ETF into a different buffer ETF with more upside potential and less downside before the buffer begins, locking in gains and potentially offering the investor a more attractive risk-reward profile.
This approach is arguably more effective than owning an equally weighted average of each series. Why would you want to own all buffered notes when you could selectively own the individual buffer ETFs with the potential to optimize returns? Not only does this strategy provide diversity in a fundamentally structured investment category, but FOFs also rebalance within the ETF wrapper, making them more tax efficient.
The ability to rebalance within an ETF wrapper provides a level of tax efficiency that is typically not available in the buffer fund space. Through the use of buffer FOF ETFs, advisors can avoid a tax event when making changes between individual buffer ETFs. This strategy will likely resonate with investors looking for both risk mitigation and reduced tax exposure.
With traditional buffer ETFs, on the other hand, it’s difficult for advisors to avoid capital gains after rebalancing into a new fund. Buffer FOFs can offer advisors a modern alternative to traditional risk-mitigation strategies that aim to resolve common headaches such as capital gains taxes.
On top of diversification and tax efficiency, buffer FOFs aim to take the reallocation burden off advisors’ shoulders. These investment products are actively managed by portfolio managers whose main responsibility is to determine which buffer series might be more attractive than others according to certain risk-reward profiles. This is done by keeping risk management and upside potential top-of-mind throughout the life cycle of the fund.
Not all buffered notes are created equal, and it’s a portfolio manager’s responsibility to pick the right one for a given portfolio.
The recent proliferation of buffer ETFs has brought a number of different individual buffer ETFs to market offering varying upside caps, downside buffer levels, and varying start and end dates to the specified outcome periods. Keeping track of all these different factors can make it difficult for advisors to distinguish between various buffer ETFs and decide which is best for a particular client.
Using a FOF approach allows advisors to lean on an investment professional who monitors a wide variety of buffer notes and selectively allocates to the individual ETFs with the best perceived risk-reward profile given the current market environment. This enables advisors to spend more time focusing on other business objectives and client-related issues.
The market is in a state of uncertainty rarely seen before, as inflation and recession fears continue to cause volatility. In addition, markets have been trading at elevated valuations for months, leading to lower returns and skewed risk-reward potential.
Advisors need to prioritize client relationships while maintaining strategic investment offerings that prioritize mitigating risk and capturing upside gains. By utilizing buffer FOFs, advisors can still potentially capture upside gains and enjoy downside risk management in a more tax-efficient manner. Going forward, advisors should consider incorporating the next generation of risk management into their portfolios to help prepare for what’s to come.
Sean O’Hara is president of Pacer ETFs Distributors ($16.1 billion in AUM as of Aug. 31, 2022), a Malvern, Pennsylvania-based ETF issuer with over 44 thematic and rules-based ETF strategies.