One of the best ways for ETF investors to beat the market this year has been to play it safe. So-called buffer ETFs, an options-based product that allows investors to protect against losses in exchange for limiting upside potential, have handily outperformed the S&P 500 in 2022, even with the recent market rally. For example, the Buffer Series offering Innovator ETFs shows consistent outperformance for funds linked to the SPDR S&P 500 ETF Trust (SPY). The Innovator US Equity Buffer January ETF ( BJAN ), which rebalanced just before the market hit record highs, is down 5.8% this year compared to 10.1% for the SPY. The August fund (BAUG), which rebalanced a few weeks ago, is down just 3.7% year to date. They’ve also proven popular, with Innovator bringing more than $1.2 billion in inflows to its defined-outcome products in the second quarter, according to the firm. CEO Bruce Bond said market volatility prompted some previously interested investors and advisers to jump into the products. “All of a sudden, when the market gets uncomfortable or really becomes an unknown, they come back and say, OK, I’m going to get involved here. I’m going to use this in a more active way,” Bond said. . The basic structure of Innovator’s funds, and competitors like First Trust, goes like this: The ETF gains market exposure through a deep out-of-the-money call option on a broad ETF, like SPY. The fund then implements a sell spread to protect against the downside. For example, the put spread could consist of buying a put at price and then selling a put 10% below the money. This would mean that, during the first 10% of a decline in the underlying asset, the fund would theoretically not suffer a loss. To help pay off this position, the fund sells another call option, which creates the “top” on the upside. Exact levels of protection and cap may vary by fund. For example, Innovator offers funds with downside protection of 9% and 15%, and 5% to 35%, in its main Buffer ETF series, and has other variations as well. First Trust offers include 10% and 25% buffers, among other products. The FT Cboe Vest US Equity Buffer ETF – January is down less than 1% this year. Source: Innovator, First Trust First Trust ETF Strategist Ryan Issakainen said Buffer ETFs can work as a replacement for a traditional 60-40 portfolio, but this year, with rising bond yields , buffer ETFs have proven to be equal. more protective than that old school strategy. Issakainen said the funds can also serve as a counterweight to riskier bets elsewhere for an investor. “They can combine a less volatile buffer ETF with some more volatile opportunistic trades,” Issakainen said. How to invest in the funds A peculiarity of these products is that, because they are based on options and do not contain the underlying index, the funds do not perfectly follow the market even between the buffer zone and the limit. Bond said the funds “ride the market” but typically see it lag the market up and down before the defined rebalancing period. Innovator offers funds for each month that hold 12-month positions. “An option has a time value early on, so it doesn’t move the same as the market. But the closer that option gets to expiration, the more market-like it becomes,” Bond said. This phenomenon can cause funds to perform worse than expected outside of rebalancing periods. Morningstar research analyst Lan Anh Tran said that in order for investors to reap the funds’ advertised benefits, it is best to buy and hold them for the defined periods. “The defined outcome comes with the expiration of the options. So if you can, hold onto it for the one-year holding period that many of these funds have, but if for any reason you need to pull out or switch opinion, there’s no guarantee,” Tran said. The rebalancing period is also important because it can affect the amount of upside left in a fund, with the recovery in stocks in recent months putting a bigger bite on the cap for funds that entered new options contracts near of the bottom of the market. For example, the SPY has already broken through the roughly 2.4% cap of Innovator’s superconservative Defined Wealth Shield ETF (BALT), which rebalanced in July. However, one good thing for investors this year is that volatility makes the call option used to create the limit more valuable to the market. As a result, the limits have increased. The newly rebalanced August fund (BAUG) has a potential net return of 21.66%, while the 11-month September fund (BSEP) can yield just 12.11%. “It’s significantly higher than this time last year. I think volatility is a good thing for these caps. When the market is volatile, caps tend to expand,” Bond said.