The Rise of Buffered Investments & 3 Reasons Why Investors Buy the Dips
Buffered Investments on the Rise
Buffered investment products, also known as defined outcome, are constructed to limit potential losses in the stock market while sacrificing some gains and dividend payments. These funds, notes, and annuities use derivatives, such as options, rather than owning underlying the index. They’re designed to provide downside protection, making them appealing to some risk-averse investors who want exposure to U.S. stocks without significant volatility. The goal is to avoid a share of market losses in exchange for limited gains. These offer a solution for those seeking downside protection with the ability to participate in a positive market environment.
Example
Assume a company issues a 15% hard-buffered ETF (exchange traded fund) with an upside cap of 12%. The protection and upside cap typically last one year. An investor is potentially shielded from 15% of the market’s declines for the next year. Assume the market drops 25%, if the investor holds for the full year, they should only lose 10%. But, if the market rises, the gains are limited on the upside too. If the market rises 25%, the investor only receives 12%.
Protection Comes at a Cost
As we know, markets generally trend upward over time. So, any would-be protection comes at a cost. Throughout history, the largest market gains have come after deep selloffs. Capping the gains on your investments can have seriously implications to long-term investment objectives. Protecting from losses in overbought markets can help preserve your financial situation. As with most investments, the higher the potential protection, the lower the expected return.
Nevertheless, these investment vehicles are growing at a rapid pace. The chart below, from Morningstar, shows the assets under management growth of options based, or buffered, ETFs (blue line). Also of note is the expansive growth of cryptocurrency-based ETFs. Some investors are constantly searching for an alternative source of risk and return beyond traditional stocks and bonds – this chart tells us that.
Source: Morningstar
Keep in mind that buffered investments require some understanding, as they’re not typical stock or bond funds. They fall somewhere in between, resembling alternative investments. Knowing where, or even if, they fit into your portfolio can be tricky. A serious conversation around risk tolerance and investment scheme is vital.
Questions to Ask
Is sacrificing upside worth the possible downside protection? We all know dividends are a key source of returns. Is foregoing dividends worth the ability to have some downside protection?
These are not one size fits all investments, but adding an element of protection to your portfolio can help you achieve long-term investment goals and, more importantly, provide some confidence in turbulent markets.
Sourced Picture:
https://www.morningstar.com/funds/prolific-first-half-etf-flows
3 Reasons Why Investors Buy the Dip
Buying the dip in the stock market is a strategy where investors buy equities after a deep sell-off., here's 3 reasons why investors buy the dip:
- Opportunity for Bargain Prices: When a stock experiences a temporary decline, it may be undervalued due to market sentiment or short-term factors. Buying during a dip allows investors to acquire shares at a potentially discounted price, which can lead to better long-term returns.
- Averaging Down and Enhanced Performance: By buying more shares during a dip, investors can "average down" their net average price. If the stock eventually rebounds, exceeding the purchase price, this strategy can enhance overall performance. However, it's essential to set thresholds and manage risks.
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Market Reversion and Upside Potential: Historically, markets tend to revert to the mean over time. Great businesses often recover from downturns, conceivably leading to improved stock performance. Investors with a long-term focus can take advantage of market pullbacks and capitalize on the potential upside when stocks bounce back.
Please note, it's impossible to know when you're really buying at a market bottom as prices may fall even further. Buying the dip is, essentially, an attempt to time the market and even the most experienced investors are unable to do this on a persistent basis. Buying the dip requires having cash in reserve, ready to use at short notice. Since that cash usually produces little or no return, it can drag down your portfolio returns and may cause you to miss out on other investment opportunities when markets are rising.
Wrap-Up
Buying the dip and buffered investments aren’t for everyone. There are specific time horizon and risk questions that come into play. As always, we encourage a thoughtful conversation with your financial advisor and welcome any questions you may have.
- Brett Miller, CFA, CFP® – Financial Advisor
- Scott Miller – Senior VP, Investments
The information contained in this blog does not purport to be a complete description of the securities, markets, or developments referred to in this material. The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of Brett Miller and Scott Miller and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Cryptocurrencies are a very speculative investment and involves a high degree of risk. Investors must have the financial ability, sophistication/experience, and willingness to bear the risks of an investment, and a potential total loss of their investment.
Hypothetical examples used in this report are for illustration purposes only. Actual investor results will vary. Buffered investments are not fully principal protected and therefore investors may receive less than their initial investment at maturity. Buffer Annuities are more complex than traditional variable annuities and may not be suitable for all investors. The principal protection offered by the buffer may not compensate for the expected value lost due to the cap on potential upside gains. Buffer Annuities include certain contractual guarantees which are subject to the creditworthiness of the insurance company providing the annuity.
Buffered ETFs have characteristics unlike other traditional investment products and may not be suitable for all investors. Any potential buffer protection the fund seeks to achieve is based on the investor remaining invested during the entire outcome period. See an individual ETF’s offering documents for information regarding an ETF’s upside cap. There is no guarantee Buffered ETFs will achieve their investment objectives.
Buffered Notes are considered complex and may not be suitable for all investors. Buffered Notes are sold only by prospectus and investors should read the prospectus and pricing supplement carefully before investing as they contain a detailed explanation of the risks, tax treatment, and other relevant information about the investment. Investors should consult accounting, legal, or tax professionals before investing.
