I’m undertaking a 1000-day reinvention project, blogging here daily to track my progress. In Wednesday Wealth, I write about money management, retirement, estate, and long-term care planning.
Most people who pay any attention probably sense that we’re in bubble times with the massive investment into infrastructure for AI training and inference. But are we circa 1998 or early 2000? The dotcom bubble kept inflating for far longer than many people expected.
I’m thinking we are closer to 2000 than 1998. The recent earnings season was wobbly, and we have recently seen the largest trading loss of all time, in the AI space, when Situational Awareness blew up from leverage and a concentration in AI hardware names.
What’s an investor to do? My solution recently has been to capture profits and move a portion of my portfolio to cash. Bonds aren’t a good option as yields keep rising, meaning the value of bonds goes down (bond yields and prices move inversely to one another). Tilting towards value stocks also seems a good idea, as these won’t fall as much as growth stocks in a correction or crash.
My advisor suggested I take a look at buffered ETFs such as these offerings from Allianz. They allegedly provide a buffer against a set percentage of market losses (5% to 20% in increments of 5 points) over a defined outcome period (three months, six months, or a year). And then returns are capped at some level such as 15%.
Funds like this use long call and put options to participate in upside and limit downside. Then they sell puts and calls (establishing short put and short call positions) to fund the long positions (which require an outlay of money).
The funds present certain limitations and tradeoffs:
- Protection is time-bound – The stated buffer applies at the end of the outcome period, not throughout.
- Capped gains can hurt in strong markets – If the market runs, you’re locked out beyond your cap.
- Portfolio fit matters – Buffer ETFs need to be integrated into a broader allocation. Treating them as a simple index substitute can lead to mismatched expectations.
- Early exit risk – Selling before the outcome period ends can lead to very different results than the marketing example suggests.
In practice, buffered ETFs can leave investors missing out on gains while still being exposed to potential large losses. They don’t protect against large tail losses, such as were seen in the dotcom crash. And they take away upside gains, such as we might see if the AI bubble keeps inflating for another year. Plus, their performance depends crucially on the timing of drawdowns.
In the abstract to their paper Rebuffed: An Empirical Review of Buffer Funds, researchers from AQR write:
Being an equity investor is hard. Volatility can be high, drawdowns can be long, and nobody can definitively (or a considerably lower bar than definitively) say when returns are going to be good or bad. Products catered to investor preferences of achieving equity-like returns with
less downside risk have been around for decades. “Defined outcome” strategies such as buffer funds are the most recent in a line of products designed to accommodate this desire and offer a wide range of customizations to fit investor objectives. Like their predecessors,
however, buffer funds don’t hold up to scrutiny, either empirically or theoretically. Once again Robert Heinlein, and his TANSTAAFL, is a better investment manager than the industry.
TANSTAAFL is “There Ain’t No Such Thing As a Free Lunch.”
The key findings of the AQR study of buffered funds are:
- Buffer funds, options-based strategies that aim to limit downside risk while capping upside, often underperform their reference assets in both returns and risk-adjustedterms, despite being marketed as investor-friendly solutions to equity volatility.
- The promised downside protection is inconsistent in practice—realized losses frequently exceed what investors might expect based on option payoff diagrams, especially outside narrowly defined periods.
- Simple alternatives like mixing equities with cash generally outperform buffer funds on average and even in drawdowns, raising questions about whether these products truly serve investor goals or just cater to behavioral preferences.
Conclusion: I’m not touching the buffered ETFs! I’ll use simpler alternatives, like “mixing equities with cash” which I’m already doing.