As you know, I am a fan of risk rotation strategies. The premise is simple. When the markets are signaling risk-on conditions by looking at utilities, lumber, gold, Treasuries or some combination thereof, investors should push into riskier assets. When conditions urge caution, investors should consider taking risk off the table.
The strategy is straightforward - take advantage of the good times, try to avoid the bad ones.
In my opinion, risk mitigation can do more for your portfolio’s performance than return maximization. Of course, that has a lot to do with loss avoidance, but it’s also about managing behavioral biases, such as loss aversion, emotional decision making and overtrading.
According to a recent DALBAR study, the average equity investor underperformed the S&P 500 by 5.5% in 2023. Over the past 30 years, the average investor has underperformed the index by nearly 3% annually. In short, investors can’t seem to get out of their own way, but if you can remove the fear triggers from the equation, investors are likely to come out better in the end.
So when a subscriber recently asked me what I thought about buffer ETFs, the question was right up my alley.
Buffer ETFs work on a similar concept - try to capture market returns when asset prices are moving higher, but protect yourself from drawdown risk when they aren’t. By essentially shrinking the potential range of returns, you reduce overall volatility and mitigate extreme drawdowns in your portfolio (most buffer ETFs protect against a percentage of losses, so there is some downside risk, although 100% downside protection ETFs exist now as well).
And that’s the real secret sauce of buffer ETFs: improving risk-adjusted returns.
Let’s go through an example of how this works. Without going through the mechanics in detail, buffer ETFs use options contracts to establish their positions and create their buffers & caps. Different ETFs establish different buffers & caps depending on what their objective is.
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