Buffered ETFs: Definition and how they work

Buffered exchange-traded funds (ETFs) can give investors built-in protection against market losses while still allowing for potential market gains. Unlike traditional ETFs that simply track an index, buffered ETFs use option strategies to limit losses over a set period. The trade-off here is they also cap potential gains. 

We’ll cover how these ETFs work, explore their risk-reward profile, and share practical tips for investors. For additional help, Gainbridge offers client-focused resources to help you understand investment strategies and move you closer to your financial goals.

What is a buffered ETF?

A buffered ETF, also called a defined outcome ETF, lets you invest in the stock market with built-in guardrails. Fund managers structure it using options to limit losses if the market drops and capture gains up to a certain cap. You can think of a buffered ETF like a partial shield: You don’t lose everything in a downturn, but there’s a ceiling on how much you can bring in.

These ETFs use a wrapper similar to traditional funds but include built-in risk controls. Buffered mutual funds follow the same principle but are structured as traditional mutual funds rather than ETFs. Both products offer controlled exposure to the stock market and a chance to grow your investment.

How buffered ETFs work

Buffered ETFs work using a three-layer options strategy, detailed below.

Layer 1: Synthetic index exposure

The ETF tracks an underlying index — like the S&P 500 — without actually owning all those stocks. With this synthetic exposure, your investment rises and falls with the market like a traditional ETF. It allows investors to benefit from index-linked returns without full market risk.

Layer 2: Downside buffer

These ETFs protect part of your investment from losses during a set period of time, usually one year. If the index drops by a certain percentage, the buffer absorbs your initial losses up to the predetermined limit. This downside buffer serves as a partial safety net to help you manage risk while maintaining market exposure.

Layer 3: Financing the buffer

The ETF generates income by selling other options, and that pays for the downside protection. Because of this trade-off, the ETF creates a cap on how much you can earn during the outcome period. This strategy creates a balance, taking away some upside potential to reduce the risk of losses.

After each outcome period, the ETF rolls into a new set of options contracts with a fresh buffer and cap levels. This annual reset keeps the strategy more consistent for investors.

Are buffered ETFs a good investment? Pros and cons

Although buffered ETFs fit well in some retirement portfolios, they're not a one-size-fits-all investment. Here’s a closer look at their strengths and limitations.

Pros

The key advantages of buffered ETFs include:

Defined downside protection: Buffered ETFs absorb losses up to a set limit. This can make it easier to remain invested in a long-term strategy, even in volatile environments.

Transparent fees: These ETFs disclose expense ratios and holdings. Because they’re typically more transparent than some other investment options, you can see where and how their fees might impact your returns.

Liquid ETF wrapper: You can buy and sell them like any other ETF, letting you adjust your portfolio as your goals change. And unlike some investments that lock up your money, you can trade buffered ETFs whenever the market is open.

Cons

Here are the common limitations to consider before deciding on a buffered ETF:

Capped upside: A big trade-off with downside protection is limited growth potential. Even if the stock market performs exceptionally well, your returns are capped during the outcome period. 

Exclusion of dividends: Buffered ETFs typically don’t pass along dividends from the underlying index. This can reduce your total return compared to traditional ETFs.

Buffer erosion: Your investment is only protected up to a certain limit. If the index drops below that buffer — for example, if the protection covers 10% but the market falls 20% — you absorb the excess loss. The buffer helps reduce risk, but it doesn’t eliminate it.

Buffered ETFs are one of many tools to help manage risk. It’s smart to compare them with other risk-management strategies, like Gainbridge Annuities, to see which one fits your financial goals.

What is a buffered annuity? 

A buffered annuity — or protected annuity — is an insurance contract that gives you market-linked growth with downside protection. Like buffered ETFs, it offers a capped upside and absorbs a portion of losses. The key difference is annuities are issued by insurance companies and may include the following extra features for long-term planning and income.

Outcome period

Buffered annuities work in set time frames, often one to six years. During each outcome period, the buffer and cap stay fixed so you know how much protection and growth potential you have. When the period ends, the annuity contract resets with updated terms. This allows the contract to adjust to changing market conditions and helps maintain consistent risk control over time.

Buffer level

Buffers protect you from a set percentage of market losses, sometimes up to 10% to 20%. The bigger the buffer level, the more protection you get, but this typically lowers the cap on gains. This trade-off lets you choose the level of risk that fits your financial plan.

Mortality/exposure considerations

Your contract might include protections like a death benefit, ensuring the annuity’s remaining value passes to your beneficiaries. Buffered annuities can also offer guaranteed income, which investors won’t find with an ETF. These benefits can be especially appealing for retirement security and estate planning.

Make your next financial moves with Gainbridge

Buffered ETFs let you participate in the stock market while managing the level of risk. But as with any investment, there are trade-offs to consider. You’ll have to decide whether this option matches your goals. 

Gainbridge offers tools and products designed to help you manage risk and plan for the future. Use their annuity calculator to explore potential outcomes and find the right type of annuity that aligns with your goals. If you have any questions, our licensed agents are available to help. Explore Gainbridge today and take your financial future into your own hands.

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This article is for informational purposes only. It is not intended to provide, and should not be interpreted as, individualized investment, legal, or tax advice. For advice concerning your own situation please contact the appropriate professional. The Gainbridge® digital platform provides informational and educational resources intended only for self-directed purposes. Guarantees are backed by the financial strength and claims-paying ability of the issuer. Investing involves risk, including the possible loss of principal. Past performance is not indicative of future results.

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