Preparing For 2023: Buffer ETFs Are Turning Into An Extraordinarily Good Deal
The downside protection and higher upside caps make these one of the most attractive deals in the markets right now.
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2023 is just a few weeks away and it seems like everyone is coming out with their year-end forecasts. From a macro perspective, the majority of people seem to believe that a recession is coming sometime in the next 12 months, but the more interesting nugget might be how Wall Street strategists see the upcoming year.
For the first time in more than 20 years, the consensus projection is that the S&P 500 will actually lose money in 2023.
With everybody predicting recession and everybody predicting another down year for stocks, I wonder if we might actually see the opposite happen. My base case expectation right now is that we actually see gains in risk assets during the first half of the year before declining in the second half. The Fed pivot trade could gain a little steam as early as this week if the Powell decides to only hike by 50 basis points, as is expected. The real pivot, which seems like it will come sometime around the end of Q1, could spark a larger rally in equities before the recession narrative begins taking over and stocks start drifting lower again.
But that’s just all predicting. I don’t know what’s going to happen. You don’t know. Nobody knows. All we can do is position portfolios in a way that protects against downside risk while allowing the capture of upside gains.
Buffer ETFs Could Be The Way To Play The Markets In 2023
Buffer ETFs have become a $20 billion industry. Without going too far into the weeds, these are the funds that invest in a portfolio of FLEX options, which are structured to effectively limit the range of returns during the outcome period. Essentially, a buffer ETF provides a predetermined level of downside protection in exchange for a cap on positive returns.
I invested in the Innovator U.S. Equity Power Buffer ETF - February Series (PFEB) at the beginning of this year. With inflation on the rise, the Fed getting ready to aggressively tighten and growth already slowing, it seemed like a good idea to layer a little protection on my portfolio. PFEB’s design was to protect against the first 15% of losses in the S&P 500, but allow positive returns up to its 10.19% cap.
Buffer ETFs are great because they’re not a pure downside hedge. They allow you to win the trade even if your investment thesis turns out to be wrong. If you think the market is going down and you’re right, you’ve got that 15% downside buffer built in. If you think the market is going down and you’re wrong, you can still capture gains up to the predetermined cap.
This combination of upside capture with downside protection makes buffer ETFs a great deal. Here’s the thing though. The deal just got better!
The Innovator U.S. Equity Power Buffer ETF - January Series (PJAN) is going to be one of my top ETF picks for 2023 because the upside caps that investors can capture have doubled!
You’ll recall I said for PFEB that it offered 15% downside protection with a 10.19% cap on returns (if you hold for the entire outcome period).
We don’t have the expected cap number for PJAN yet, whose outcome period will start in about three weeks or so, but we can look to the October, November and December buffer ETFs to get an idea of what it could look like. PDEC just reset at the beginning of this month with a cap of 18.37%.
The October and November ETFs currently have caps of more than 20%!
Your mileage, of course, will vary depending on what you’re looking to accomplish in your portfolio. For me, this is an incredibly good deal for investors and a rare opportunity to have your cake and eat it too.
Unless you believe that the S&P 500 is going to gain more than 18.37% in 2023 (and I’m not sure I’ve come across anyone who believes this yet), you’re essentially getting an investment in the index with a 15% loss buffer as a bonus in case things go south. You’ll not find many deals better than this in the markets today.
The risk, of course, is that returns fall outside of this range. As the graphic above illustrates, investors will be exposed to downside risk should losses exceed 15% in the outcome period. If the S&P 500 ends up falling 35%, PJAN will still decline in value by 20%. That’ll provide some solace in that investors didn’t lose as much as the market, but there’s still the possibility of experiencing losses. It doesn’t eliminate downside risk altogether.
Same thing for the upside capture. If the S&P 500 gains 30% in 2023, your return in PDEC would, in theory, cap out at 18.37%, leaving you short on matching the market.
If the downside buffer & cap numbers aren’t quite what you’re looking for, there are other options as well. The Power Buffer ETFs come with 15% downside protection. The straight Buffer ETFs come with a smaller 9% downside protection, but offer a higher cap on returns. Expecting big losses for stocks next year? The Ultra Buffer ETFs might be for you. They offer protection from losses between -5% and -30%, but come with a lower cap on returns.
Buffer ETFs have become one of the ETF space’s best innovations over the past few years. Their combination of downside protection with upside potential allows regular investors a great way to risk-manage their portfolios in a way that they probably wouldn’t otherwise be able to without access to and knowledge of the options market.
In 2023, the buffer/cap figures have gotten incredibly attractive and investors would be wise to consider them for their own portfolios in the coming year.