Buffer investment strategy

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A buffer investment strategy is an investment strategy that generally aims to mitigate downside risk and has returns that are typically capped on the upside. Beginning in the 1980s, structured notes offered by banks provide packaged access to derivatives that seek to deliver targeted returns over specific investment horizons, typically used by larger institutional investors. Beginning in 2010, buffer protection strategies became accessible in annuities. Versions of the downside buffer protection strategy then became available in registered products due to Cboe Vest Financial LLC's methodology using FLEX options allowing for similar investment outcomes. These versions of the strategy first were launched within mutual funds in 2016, followed by exchange traded funds (ETFs) in 2018, and unit investment trusts (UITs) in 2019, in order to provide the outcome driven investments to a broader set of investors.

Explanation

A buffer investment strategy is a type of risk mitigation strategy with exposure to an underlying reference asset (i.e. an index, stock, bond, etc.) which can be delivered in the form of structured notes, annuities and registered investment products (i.e. mutual funds, ETFs, and UITs). Buffer strategies have a specific time horizon - they aim to deliver the specified outcome on an expiration date. The strategy seeks to protect the investor from a predetermined amount of downside losses while allowing a level of upside participation typically up to a cap. The buffer strategy is structured using derivatives, such as options, that are linked to the performance of the reference asset from the date of initiation of the strategy through the expiration date.

The construction of the buffer strategy is a variation of a put-spread collar strategy, implemented using options or other derivatives, where the cost of put-spread that creates the downside protection is often financed by the sale of call options that cap upside participation. The "buffer" protects the investor from a specific range of downside losses, based on the level of the reference asset at purchase. For example, a 10% buffer would protect the investor from drops in the reference asset from 0%-10% from the prevailing reference asset price level at time of purchase, although there are other structures including buffers that kick in after a certain level of losses, e.g. 5%. Buffer strategies also typically feature a cap on the price appreciation of the reference asset, however this is not always the case. A cap allows participation up until a predetermined level and is usually used to finance the downside protection. When the strategy is held to maturity until the expiration date, the returns of the strategy can be realized. Strategies in mutual funds and ETFs are replaced—sometimes referred to as rolled—into a new strategy covering a similar horizon, e.g. 12 months. Buffer strategies within registered fund products do not provide a capital guarantee on the principal invested, unlike some structured notes and annuities. The strategy tends to be complex in nature. Because of the downside risk mitigation, these strategies tend to have lower risk than the corresponding reference asset, with the degree of risk reduction determined by the remaining term and range of protection of the strategy.

Evolution

The roots of the buffer investment strategy began with the use of modern derivatives, which gained popularity in the 1970s. At the start, derivatives were used on their own to allow savvy investors to structure their outcomes by hedging risk. The average investor along with some institutional investors, found these types of targeted outcomes and risk mitigation strategies too complex to utilize because of the technical nature of the instruments. Regulators also warned investors to refrain from using derivatives securities unless the investor fully understands the investment and risks involved.

Structured notes, introduced in the 1980s, packaged these derivatives into a debt instrument, which opened the derivatives market up to a broader set of institutional investors and high net worth individuals. Beginning in 2010, buffer protection strategies became accessible in annuities. The desirable attributes of buffer structured notes and annuities, along with their targeted payoffs, created some popularity in these investments, however issues in terms of lack of liquidity and credit risk became evident.

Asset management firms interested in the benefits of buffer strategies without the issues of structured notes and annuities saw an opportunity to package the strategy in products that are registered under the Investment Company Act of 1940 (40-Act funds) and make them accessible to a broader set of investors. A methodology was created by an asset management firm, Cboe Vest Financial LLC, which detailed the use of FLEX options to create buffer investment strategies in registered funds, particularly UITs, in their patent application published in 2014. Following this, the firm created an online platform for investors less familiar with options to structure and execute the risk-adjusted outcomes using these FLEX options on the back end.[1] [2] Cboe Vest Financial LLC then developed the first Target Outcome Indexes which were published by the Chicago Board Options Exchange (CBOE) in April 2016. The first buffer strategies launched within a registered fund came in the form of mutual funds. Cboe Vest Financial LLC filed for the first buffer mutual funds as point-to-point monthly versions beginning in 2016.[3] Following this, asset management firms developed buffer registered funds with similar constructions in mutual funds, UITs, and ETFs.

Structured products

Structured products were first introduced in Europe in the 1980s, expanded globally, and grew to a $7 trillion market by 2018. In the U.S., government sponsored entities, such as banks with strong credit, issue these debt securities.

Structured notes

Banks were the first to provide these customized outcome-based investments in the form of structured notes for use among institutional investors. By 2006 they were made available to individual investors as well.

Structured notes, also known as market-linked investments, are unsecured debt obligations of the issuer with returns that are linked to the performance of a reference asset (such as commodities, equity indexes, stocks, etc.). Structured notes provide certain advantages over other investments at managing risk including the ability to customize based on appetite for risk, lower transaction costs, and better operating efficiencies to name a few. However, industry regulators including the SEC and Federal Reserve have cited concerns about the complexity of the payoffs, limited liquidity (as they are not exchange-traded), and associated credit risk (as unsecured debt obligations of the issuer).

In 2005, structured notes sales were up 57% and in 2006 around 1,400 structured notes were available to U.S. investors. The structured notes market was growing substantially around this time up until 2008, when the Lehman Brothers collapse triggered by the subprime mortgage crisis, brought to light the product's inherent credit risk. Investors in Lehman Brothers structured notes lost over $18 billion and the damage was felt world-wide. Structured notes are still a popular investment today, being sold by most of the largest investment banks and firms across the globe.

Buffer annuities

Buffer annuities were introduced in 2010 by AXA Equitable Life Insurance Co. (now Equitable Financial Life Insurance Co). Buffer annuities, also referred to as structured, shield, variable-indexed, and registered index-linked annuities (RILAs), are a subset of variable annuities. They act as a form of insurance on an investment linked to a market index in which a portion of upside is traded away in exchange for protection against some downside. Because they intend to act as protection to the investment, provide regular payments, and enhanced death benefits, buffer annuities tend to be popular among investors in and nearing retirement. Like structured notes, they provide returns that are linked to the performance of a market index, feature a specific percentage of buffer to downside, and have a cap on the upside. As with structured notes, investors have been warned by many sources about the complexity of these products and the credit risk involved. A partial list of firms offering buffer annuities includes Equitable Financial Life Insurance Co., Brighthouse Financial Inc., Allianz Life Insurance Co. of North America, and CUNA Mutual.

Registered products

The method of using FLEX options to construct buffer strategies in registered funds came to existence in 2014, when the patent by Cboe Vest Financial LLC for outcome-oriented investing was published. Funds that are registered under the Investment Company Act of 1940 are subject to greater regulation and accountability than structured products, which are regulated as corporate debt issues. The registered product strategy was packaged this way to solve the inherent credit risk, illiquidity and lack of transparency of structured notes and buffer annuities, while opening the door for broader access to the buffer strategy by retail investors.

Mutual funds

The buffer strategy was first offered in a mutual fund in August 2016, launched by Cboe Vest Financial LLC.[4] This filing for 12 mutual funds offered the buffer strategies as point-to-point monthly investments. Buffer mutual funds, sometimes referred to as defined outcome funds or structured mutual funds, seek to deliver the same results as other buffer strategies: track a reference asset, provide downside protection, a level of upside participation, and typically have a cap on upside participation. They are constructed using FLEX options and a laddering technique for combining buffer investment strategies that have different expiration dates. In short, a laddered, diversified or rolling strategy means the products are composed of twelve year-long strategies, each beginning on a different month, with buffers and caps reflecting current market conditions at the time the strategy launches or rolls.[5] Some risks of these investments include that the investment objective is not guaranteed and the use of leverage—which can amplify movements in underlying derivatives.[6] Buffer mutual funds are a niche market, with a few firms in the industry as of 2020. A partial list of portfolio managers offering similar buffer mutual funds include Cboe Vest Financial LLC, Beacon Trust and Catalyst Capital Advisors LLC.

Exchange Traded Funds (ETFs)

The first buffer ETF series was filed with the SEC by Cboe Vest Financial LLC in 2017, and the first ETF series was subsequently brought to market in 2018 by Innovator Capital Management LLC, followed by a proliferation of competing products. Buffer ETFs are also known as target outcome, defined outcome, buffered outcome, or structured ETFs.[7] Buffer ETFs function in the same manner as structured notes, offering a level of downside protection in exchange for an upside cap for a specified time period, while tracking the performance of an underlying reference asset. The buffer ETF industry grew significantly during the period of heightened volatility at the beginning of 2020, as financial markets reacted to the economic impact of the COVID-19 virus. By May 2020, inflows into buffer ETFs exceeded $1.9 billion year to date, as compared to $1.49 billion flows for all of 2019. As of June 30, 2020, buffer ETFs totaled over $4 billion in assets. Buffer ETFs popularity also came with skepticism about fees and some risks including that they are not guaranteed products and similarly to structured notes, they do not include dividends in their performance. A partial list of asset management companies in the space includes First Trust L.P., Innovator Capital Management LLC, New York Life Investments LLC and Allianz Investment Management LLC.

Unit Investment Trusts (UITs)

The first buffer UIT was filed with the SEC by Cboe Vest Financial LLC (under the name Convexcel) in 2013. The firm subsequently launched the first buffer UIT in 2019 in partnership with First Trust L.P. Buffer UITs are also sometimes known as buffered market linked trusts (MLTs), structured UITs (SUITs) or defined outcome trusts. These trusts seek to provide a downside buffer, while providing upside participation of an underlying asset for specified term similar to other buffer investment products. Upside participation in positive performance of the underlying asset may be capped and leveraged.[8] Unlike other registered investment companies, UITs are not actively managed and are required to maintain a relatively fixed portfolio. Some consider these to be advantages in comparison to other structured registered products as they can provide more transparency. Product providers in the space include Alaia Capital LLC, Guggenheim Investments LLC, and First Trust L.P.

References

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