The same people who prefer owning high-dividend stocks and partnership units may gravitate toward defined-outcome funds and Structured Notes. But what sets the two apart? Why choose one over the other? Let’s delve into both of these yield-focused investment types and determine how they fit into a well-balanced portfolio.

What Are Buffered ETFs?

Buffered ETFs, also known as defined-outcome funds, are a type of ETF that combines elements of traditional ETFs with downside-protection strategies crafted using options. While the terms and features of each Buffered ETF vary, they generally have a predetermined buffer, which acts as a shield against a set percentage of losses on an underlying index. The buffer is like the holder’s safety net, absorbing market drawdowns up to a specified limit. Since this protective investment strategy is within the ETF wrapper, there can be strong liquidity along with periodic rebalancing to maintain the intended level of protection.

Buffered ETFs are designed to offer investors market participation with downside risk management, but timing entries and exits is important. Sometimes referred to as Structured ETFs or target-outcome funds, they can yield strong returns up to a stated cap and have a maturity date, normally 12 months after issuance.

It’s key to understand the four main components of Buffered ETFs: 

Maturity

This is the duration of the investment. It is the period during which the ETF’s performance, including its downside protection and potential upside, is measured. Maturities may range from a few months to several years. It’s generally sound practice for investors to match their time horizon with the maturity of a Buffered ETF.

Underlying Asset

The underlying asset is the financial index or security to which the Buffered ETF is linked. While the most common underliers are major equity indexes, such as the S&P 500, Dow Jones Industrial Average, and NASDAQ Composite (or NASDAQ 100), there are hypothetically any number of possible underliers depending on investor demand. The performance of the underlying asset determines the overall returns and risk profile of a Buffered ETF. In general, the more volatile an underlier is, the more yield potential there can be.

Protection Amount

The protection amount is arguably a Buffered ETF’s defining feature. By using a derivatives package of options, the ETF issuer can construct a defined outcome profile, including stated downside protection. The protection amount is a percentage of losses the holder is not exposed to. For example, if a Buffered ETF has a 10% protection amount, the investor is shielded from the first 10% of losses in the underlying asset. The holder may be exposed to market losses beyond that 10% buffer, though.

Return/Payoff

A Buffered ETF’s payoff structure determines how investors can benefit from holding the fund from its inception to maturity. These ETFs often have a capped return. That means that while there is a degree of downside risk protection, the tradeoff is that returns may be limited compared to uncapped returns on an underlying stock index. The return is usually expressed as a participation rate, but might not include the dividends produced by the underlier. It is essential that prospective investors realize this risk/return tradeoff.

What Are Structured Notes?

Structured Notes work similarly to Buffered ETFs, just without the ETF wrapper. Like defined-outcome funds, Notes are popular with risk-conscious investors who seek a higher yield from their portfolios. Structured Notes have the same four components as Buffered ETFs listed above, but there are additional benefits to this type of protective investment. Structured Notes may work better for investors since holding them to maturity does not involve seeing constant NAV and ETF share-price changes (as a holder would experience with Buffered Funds). Other important features differentiate the two types of protective investments.

Structured Notes and Buffered ETFs: Key Differences

On paper, there isn’t a major gap between Notes and defined-outcome funds, but there are nuances that may tilt one more favorably than the other depending on the investor:

• Customization: Structured Notes offer a high degree of customization, allowing investors to tailor terms according to their preferences. Buffered ETFs, in contrast, are more standardized and considered “off-the-shelf” options for retail investors. 
• Issuers: Structured Notes are typically provided by large financial institutions, often major Wall Street banks. In contrast, Buffered ETFs are products of ETF issuers, and have tickers you might find scrolling across the screen on financial TV. 
• Market Presence: The Structured Notes market has a long-standing history, spanning decades and accumulating to over $3 trillion globally. Buffered ETFs, while experiencing rapid growth, represent a smaller segment within the overall ETF universe.
• Liquidity: Structured Notes may not be ideal if a prospective investor wishes to sell before the maturity date. While Halo provides a marketplace based on competition among issuers, there is no guarantee that there will be bids if a Noteholder looks to sell. Buffered ETFs, by contrast, are generally more liquid during typical market trading hours.

Buffered ETFs and Structured Notes: A Portfolio Perspective

At a high level, however, both Buffered ETFs and Structured Notes can fit in an investor’s diversified portfolio. Often plotting between stocks and bonds on a risk-and-return graph, these hybrid securities have the potential to dampen overall portfolio volatility. There is also the behavioral upside that suggests when a bear market strikes, Buffered ETFs and Structured Notes may be able to limit the overall portfolio drawdown.

Before buying either vehicle, investors must weigh their unique risk tolerance and return objectives. Buffered ETFs are generally more standardized, while Structured Notes offer a higher level of customization, but with added complexity. Some pundits suggest that Buffered ETFs may be more appealing during volatile markets while Structured Notes’ customization has advantages in stable markets. But if an investor might turn skittish by seeing a Buffered ETF’s share price move up and down, then a Structured Note might be more appropriate.

Investors working with a financial advisor have the potential advantage of crafting unique notes that fit their specific financial objectives. Notes can be used for highly speculative trades, pouncing on short-term opportunities, as well as for the most conservative strategies, such as building a portfolio of low-risk, yield-focused holdings. Buffered ETFs, by contrast, have a relatively limited range of risk-and-return profiles.