Buffer exchange-traded funds (ETFs), also known as structured outcome ETFs, allow investors to track the performance of an asset or index. These solutions are newer to the market and growing in popularity.

Richard Ho, Director, ETF Distribution, BMO Global Asset Management, details what buffer ETFs are, and how they can provide investors with downside protection on their equity holdings.

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Q: How do buffer ETFs work?

Richard Ho: There are a couple of key things to understand. Buffer ETFs are designed to provide investors equity exposure with a predetermined level of downside protection. To obtain that downside protection, the portfolio manager uses a put spread, which is an option strategy that allows the investment to shield itself from market losses during the outcome period. For instance, BMO’s buffer ETFs protect investors for the first 15% of losses of the reference asset. It’s important to know what the reference asset is because it will deliver the market performance return of that reference asset or index. BMO US Equity Buffer Hedged to CAD ETFs provide exposure to the S&P500 hedged to Canadian dollars (Tickers: ZOCT, ZJAN and more recently ZAPR).    

To finance that buffer protection, the fund manager implements a call option. So, whenever investors sell options in the market, they earn an option premium, which is collected and used to pay for the insurance policy, that put spread. In addition, the buffer ETF has an upside cap on what the investor can expect over the lifespan of the ETF, typically a one-year term.

Q: How do buffer ETFs allow an investor to reshape the return profile of their portfolio?

RH: Buffer ETFs can help reshape the return profile by leveraging the options market to make it more attractive to investors who are more risk averse and want to protect their portfolios from market downturns without stepping away from the market. Utilizing buffer ETFs can help mitigate the risk of unknown market downturns while still maintaining exposure to the market.

How much to allocate towards a buffer ETF depends on an investor’s individual risk tolerance and time horizon. For some investors, including buffer ETFs as part of the overall construction of their portfolio could be beneficial.

Q: What is the difference between a long-only strategy and a buffer?

RH: When you use a buy-and-hold strategy, you’re exposed to market risk with no risk management or downside risk protection. But, if the investor is using a buffer strategy, they have that protection in case the market pulls back. For example, if the market is down 10%, the long-only investor is going to be down that 10%. Whereas the buffer investor’s losses will be shielded by that buffer, with the buffer absorbing the first 15% of those market losses.

The other thing that’s very compelling is the market drawdown. Let’s say the market drops by 20%. For the long investor to come back and break even to the initial point of their portfolio, it’s going to require a 25% gain to break even. But for the investor using a buffer strategy, it’s going to take only 5% to break even.

Q: How do buffers protect against volatility?

RH: Options are a great risk management tool. During times of extreme volatility, the correlations between the equity and fixed income markets tend to converge. For instance, during the financial crisis or the COVID-19 pandemic, the correlations between these two asset classes were very high. But with options, it’s a different story because the terms of the options contract embedded inside the buffer have to be respected, no matter what. Investors using a buffer ETF can navigate through volatile markets and have that downside protection.

Q: Are there any risks in using buffers?

RH: Buffer ETFs are created to reduce risk by having an embedded risk management strategy inside the portfolio. Investors enjoying this risk reduction strategy via options are trading away some of the upside. If the market goes up beyond the upside cap, then the investment might incur what we call opportunity costs. Buffer ETFs resonate with investors who are looking for less volatility in their portfolio and are willing to trade a little upside for that downside protection.

Q: What type of markets are best suited for buffer ETFs?

RH: Buffer ETFs are good for markets where there is a lot of uncertainty and volatility, such as a high level of geopolitical risk. Right now, there’s tension everywhere around the world. By having a buffer, investors get risk protection on the downside while still being invested in the market.

In summary, for financial advisors seeking to optimize client portfolios, integrating buffer ETFs can be a prudent strategy, particularly for those investors who want to remain in the market but are seeking downside protection and are willing to give up a little of the upside potential for that risk management.

DISCLAIMER

An investor that purchases Units of a Structured Outcome ETF other than at starting NAV on the first day of a Target Outcome Period and/or sells Units of a Structured Outcome ETF prior to the end of a Target Outcome Period may experience results that are very different from the target outcomes sought by the Structured Outcome ETF for that Target Outcome Period. Both the cap and, where applicable, the buffer are fixed levels that are calculated in relation to the market price of the applicable Reference ETF and a Structured Outcome ETF’s NAV (as Structured herein) at the start of each Target Outcome Period. As the market price of the applicable Reference ETF and the Structured Outcome ETF’s NAV will change over the Target Outcome Period, an investor acquiring Units of a Structured Outcome ETF after the start of a Target Outcome Period will likely have a different return potential than an investor who purchased Units of a Structured Outcome ETF at the start of the Target Outcome Period. This is because while the cap and, as applicable, the buffer for the Target Outcome Period are fixed levels that remain constant throughout the Target Outcome Period, an investor purchasing Units of a Structured Outcome ETF at market value during the Target Outcome Period likely purchase Units of a Structured Outcome ETF at a market price that is different from the Structured Outcome ETF’s NAV at the start of the Target Outcome Period (i.e., the NAV that the cap and, as applicable, the buffer reference). In addition, the market price of the applicable Reference ETF is likely to be different from the price of that Reference ETF at the start of the Target Outcome Period. To achieve the intended target outcomes sought by a Structured Outcome ETF for a Target Outcome Period, an investor must hold Units of the Structured Outcome ETF for that entire Target Outcome Period.

Commissions, management fees and expenses all may be associated with investments in exchange traded funds. Please read the ETF Facts or prospectus of the BMO ETFs before investing. Exchange traded funds are not guaranteed, their values change frequently and past performance may not be repeated.

For a summary of the risks of an investment in the BMO ETFs, please see the specific risks set out in the BMO ETF’s prospectus. BMO ETFs trade like stocks, fluctuate in market value and may trade at a discount to their net asset value, which may increase the risk of loss. Distributions are not guaranteed and are subject to change and/or elimination.

BMO ETFs are managed by BMO Asset Management Inc., which is an investment fund manager and a portfolio manager, and a separate legal entity from Bank of Montreal.

This material is for information purposes. The information contained herein is not, and should not be construed as, investment, tax or legal advice to any party. Particular investments and/or trading strategies should be evaluated relative to the individual’s investment objectives and professional advice should be obtained with respect to any circumstance. ®/™Registered trademarks/trademark of Bank of Montreal, used under license.

Many people have noted that a higher interest rate environment and geopolitical uncertainty is causing ongoing volatility in the markets. As a result, investors are seeking risk management strategies that can assist them in navigating market unpredictability.

Richard Ho, Director, ETF Distribution, BMO Global Asset Management, discusses how buffer exchange-traded funds (ETFs)—unique investment vehicles—offer risk management, and can be a prudent part of an investor’s overall investment portfolio.

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Q: What do investors need to be aware of when considering buffer ETFs?

Richard Ho: There are a few key components that investors need to pay attention to. First is the reference asset, which is the underlying asset the ETF return is based on. Let’s say the buffer ETF is in reference to the S&P 500 hedged in Canadian dollars. This means the buffer will provide S&P 500 currency hedged price returns, up to cap, and will also provide downside protection. The latter is called the buffer protection, which is the predefined protection the investor will get over the outcome period of the buffer ETF.  The BMO US Equity Buffer Hedged to CAD ETFs provide exposure to the S&P 500 hedged to Canadian dollars (Tickers: ZOCT, ZJAN, and more recently, ZAPR).   

The other element is the upside cap, which tells the investor what their potential maximum upside is.

Lastly, there’s the outcome period, which is typically one year. For instance, if the investor buys a buffer ETF on Jan. 2, it will have a lifespan of approximately 365 days. Of course, a buffer ETF is perpetual, meaning the investor can hold that same buffer ETF even after that one-year period. After that one-year period, the investor will still get that same downside protection (in BMO’s case, that’s 15%) for the next period, but that upside cap will simply reset at new levels based on market conditions.

Q: How do buffer ETFs differ from traditional ETFs?

RH: A buffer ETF is designed to help investors achieve the price return, up to a cap, on the reference asset with downside protection, which is obtained by using different option strategies. Whereas, with a traditional ETF, investors simply have the exposure return without any downside protection; there aren’t any option strategies embedded inside traditional index ETFs.

Q: What benefits do buffers offer investors?

RH: Buffer ETFs allow investors to stay invested during periods of volatility without experiencing the full market drawdown because of the buffer zone, or downside protection. These products are especially attractive to investors who are more risk averse or nearing retirement, as they may not want to take on additional risk in their portfolios. So, a buffer ETF could be a consideration to help manage market uncertainty and risk as part of their overall investment portfolio.

Q: How do buffers integrate risk management while allowing for upside participation?

RH: Risk management is offered by integrating put options, which are essentially an insurance policy for your investment. The put spread hedge will absorb a defined amount of loss, giving investors comfort in dialing down equity risk. To finance that insurance policy, we sell call options. These two strategies together allow us to package a cost-effective (the management fee is 0.65%), transparent way for investors to stay invested in equity markets with predefined protection. So if the market is going to be more volatile, they will still be protected or shielded against the first 15% of market losses.

Q: What types of investors are buffers most suited for?

RH: Investors who prioritize the benefits of having a risk management solution embedded inside an ETF could consider using buffer ETFs. Most investors tend to fall into a few categories. First, there’s the investor who is very risk averse or conservative; they are known to prioritize capital preservation. They want to minimize risk, and they’re not doing anything to strive for a home run in their investments. What they want is long-term growth, and stability. That’s what buffer ETFs can provide.

Second, many investors right now are sitting on the sidelines, in cash. They don’t have much appetite for risk. Maybe getting a 5% yield on their fixed income or GICs is sufficient. These investors sitting in cash could consider buffer ETFs because they can return to equity markets with less downside risk.

In terms of demographics, retirees who depend on their investments for retirement could also reap the benefits from buffer ETFs. That’s because they aim to safeguard their portfolios against market downturns, ensuring the protection of their savings for retirement. Again, a buffer ETF is a good solution for that. Overall, buffers are beneficial for investors who prioritize capital preservation and want stability, which is, essentially, everyone.

DISCLAIMER

An investor that purchases Units of a Structured Outcome ETF other than at starting on the first day of a Target Outcome Period and/or sells Units of a Structured Outcome ETF prior to the end of a Target Outcome Period may experience results that are very different from the target outcomes sought by the Structured Outcome ETF for that Target Outcome Period. Both the cap and, where applicable, the buffer are fixed levels that are calculated in relation to the market price of the applicable Reference ETF and a Structured Outcome ETF’s NAV (as Structured herein) at the start of each Target Outcome Period. As the market price of the applicable Reference ETF and the Structured Outcome ETF’s NAV will change over the Target Outcome Period, an investor acquiring Units of a Structured Outcome ETF after the start of a Target Outcome Period will likely have a different return potential than an investor who purchased Units of a Structured Outcome ETF at the start of the Target Outcome Period. This is because while the cap and, as applicable, the buffer for the Target Outcome Period are fixed levels that remain constant throughout the Target Outcome Period, an investor purchasing Units of a Structured Outcome ETF at market value during the Target Outcome Period likely purchase Units of a Structured Outcome ETF at a market price that is different from the Structured Outcome ETF’s NAV at the start of the Target Outcome Period (i.e., the NAV that the cap and, as applicable, the buffer reference). In addition, the market price of the applicable Reference ETF is likely to be different from the price of that Reference ETF at the start of the Target Outcome Period. To achieve the intended target outcomes sought by a Structured Outcome ETF for a Target Outcome Period, an investor must hold Units of the Structured Outcome ETF for that entire Target Outcome Period.

Commissions, management fees and expenses all may be associated with investments in exchange traded funds. Please read the ETF Facts or prospectus of the BMO ETFs before investing. Exchange traded funds are not guaranteed, their values change frequently, and past performance may not be repeated.

For a summary of the risks of an investment in the BMO ETFs, please see the specific risks set out in the BMO ETF’s prospectus. BMO ETFs trade like stocks, fluctuate in market value and may trade at a discount to their net asset value, which may increase the risk of loss. Distributions are not guaranteed and are subject to change and/or elimination.

BMO ETFs are managed by BMO Asset Management Inc., which is an investment fund manager and a portfolio manager, and a separate legal entity from Bank of Montreal.

This material is for information purposes. The information contained herein is not, and should not be construed as, investment, tax or legal advice to any party. Particular investments and/or trading strategies should be evaluated relative to the individual’s investment objectives and professional advice should be obtained with respect to any circumstance. ®/™Registered trademarks/trademark of Bank of Montreal, used under license.

Slowing economic growth is causing investors to be more cautious with their portfolios as they search for solutions to complement equity holdings. One solution could be buffer exchange-traded funds (ETFs), which provide diversification and downside protection.

Chris McHaney, Portfolio Manager, ETFs, at BMO Global Asset Management (BMO GAM), explains how buffers work in a variety of markets to provide a hedge against volatility.

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Q: How do buffer ETFs work?

Chris McHaney: Buffer ETFs are built through an option overlay strategy. There are a few steps involved. First, we get that broad equity market exposure. At BMO GAM, we invest in the S&P 500, which has the most liquid options market, and that’s what makes it very efficient to run a strategy like this. That broad equity market exposure is combined with a protective option overlay that provides protection against the first 15% of losses over a one-year period. The full benefit of that buffer, of that protection, is achieved when that option matures at one year. BMO launches a new buffer ETF every three months to provide investors with different options based on market conditions. For instance, we launched ZOCT in October 2023, ZJAN in January this year, and, more recently, ZAPR in April.

These are all invested in S&P 500 hedged to Canadian dollars equity index ETF with that first 15% of losses protected against any market loss. The way to pay for that level of protection is to cap the upside potential in the portfolio. Say the market continues to rally strongly. At some point, the buffer ETF investor stops participating in that growth. So, what they’re getting is participation in the markets with protection against downside risk.

By launching one of these buffers every three months—ultimately having four of them in the market at a time in any given year—investors will have a few different options. So, at any particular time, one of those strategies may be attractive to them in terms of risk control.

“Buffer ETFs are important tools for investors due to factors such as stock/bond correlation, and the behavioural aspect of investor psychology.”

Q: Why is a buffer ETF a good solution in the current market?

CM: Many experts and analysts have noted that there is an expectation of slowing economic growth, particularly in Canada[1]. Add to that the rising concentration of a few stocks that are

driving the market[2], which increases idiosyncratic risk for investors. Finally, there is a rising correlation between stocks and bonds, making it less optimal to rely on fixed income investments for risk control. Pulling all these things together, it can make investors more defensive or cautious when it comes to equity investments. Buffer ETFs provide explicit protection against downside risk in equity portfolios, making them a more effective hedge than fixed income investments.

Q: How can a buffer ETF complement core equity positions?

CM: Buffers add risk control and protection against downside risk while still maintaining equity exposure. For instance, a slightly cautious investor can take some of their equity allocation and put it into a buffer ETF. An even more cautious investor can take a larger allocation of their equity portfolio and put a larger portion of that into a buffer ETF. Either way, a buffer ETF adds a higher level of protection into their portfolio.

Q: How are BMO’s buffer ETFs performing?

CM: There aren’t many similar solutions in the market right now. Our buffers are providing a smoother return path compared to the market. That’s because each buffer has a defined level of protection, so you won’t go as low as the market. And, if the market rallies, then the upside cap will cause the buffer to lag. Over time, the buffer ETF will trend toward that structured outcome that is put in place as it gets closer to the end of that one-year period.

Q: Why is a buffer an important tool going forward?

CM: Buffer ETFs are important tools for investors due to factors such as stock/bond correlation, and the behavioural aspect of investor psychology. It’s hard to time the market. Emotions can cause investors to sell when the market is down. Studies have shown that when it comes to gains and losses, the pleasure you get from a 10% gain in your portfolio is less than half of the pain you feel from a 10% loss.[3] So, having that hedge naturally in place in your portfolio helps you to mitigate downside risk, allowing you to sleep better at night.

DISCLAIMER

An investor that purchases Units of a Structured Outcome ETF other than on the first day of a Target Outcome Period and/or sells Units of a Structured Outcome ETF prior to the end of a Target Outcome Period may experience results that are very different from the target outcomes sought by the Structured Outcome ETF for that Target Outcome Period. Both the cap and, where applicable, the buffer are fixed levels that are calculated in relation to the market price of the applicable Reference ETF and a Structured Outcome ETF’s NAV (as Structured herein) at the start of each Target Outcome Period. As the market price of the applicable Reference ETF and the Structured Outcome ETF’s NAV will change over the Target Outcome Period, an investor acquiring Units of a Structured Outcome ETF after the start of a Target Outcome Period will likely have a different return potential than an investor who purchased Units of a Structured Outcome ETF at the start of the Target Outcome Period. This is because while the cap and, as applicable, the buffer for the Target Outcome Period are fixed levels that remain constant throughout the Target Outcome Period, an investor purchasing Units of a Structured Outcome ETF at market value during the Target Outcome Period likely purchase Units of a Structured Outcome ETF at a market price that is different from the Structured Outcome ETF’s NAV at the start of the Target Outcome Period (i.e., the NAV that the cap and, as applicable, the buffer reference). In addition, the market price of the applicable Reference ETF is likely to be different from the price of that Reference ETF at the start of the Target Outcome Period. To achieve the intended target outcomes sought by a Structured Outcome ETF for a Target Outcome Period, an investor must hold Units of the Structured Outcome ETF for that entire Target Outcome Period.

Commissions, management fees and expenses all may be associated with investments in exchange traded funds. Please read the ETF Facts or prospectus of the BMO ETFs before investing. Exchange traded funds are not guaranteed, their values change frequently, and past performance may not be repeated.

For a summary of the risks of an investment in the BMO ETFs, please see the specific risks set out in the BMO ETF’s prospectus. BMO ETFs trade like stocks, fluctuate in market value and may trade at a discount to their net asset value, which may increase the risk of loss. Distributions are not guaranteed and are subject to change and/or elimination.

BMO ETFs are managed by BMO Asset Management Inc., which is an investment fund manager and a portfolio manager, and a separate legal entity from Bank of Montreal.

This material is for information purposes. The information contained herein is not, and should not be construed as, investment, tax or legal advice to any party. Particular investments and/or trading strategies should be evaluated relative to the individual’s investment objectives and professional advice should be obtained with respect to any circumstance. ®/™Registered trademarks/trademark of Bank of Montreal, used under license.

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[1] www.conferenceboard.ca/insights/canadas-economy-enters-a-slowdown/, www.imf.org/en/Publications/WEO/Issues/2023/10/10/world-economic-outlook-october-2023

[2] Watch Concentration of the Bull Market – Bloomberg Bull Market – Bloomberg

[3] Prospect Theory: An Analysis of Decision Under Risk, Daniel Kahneman and Amos Tversky, Econometrica, 1979.