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 hedge against losses in exchange for capping upside potential, easily beat the S&P 500 in 2022, even with the recent market rebound. For example, the Buffer Series offered by Innovator ETFs has consistently outperformed funds linked to the SPDR S&P 500 ETF Trust (SPY). The Innovator US Equity Buffer ETF for January (BJAN), which rebalanced just before the market hit record highs, has fallen 5.8% this year, compared to 10.1% for the SPY. The August fund (BAUG), which rebalanced a few weeks ago, is down only 3.7% since the start of the year. They’ve also proven popular, with Innovator generating more than $1.2 billion in inflows into its defined-outcome products in the second quarter, according to the company. CEO Bruce Bond said market volatility had motivated some previously interested investors and advisers to jump into the products. “All of a sudden when the market gets choppy or gets really unknown, they come back and say, okay, I’m going to get involved here. I’m going to use it more actively,” Bond said. . The basic structure of funds from Innovator and competitors like First Trust is as follows: The ETF gains exposure to the market through a deep-in-the-money call option on a broad ETF, like SPY. Then the fund implements a sell spread to protect against declines. For example, the put spread could be to buy a put option at the money and then sell a put option 10% below the money. This would mean that for the first 10% of a decline in the underlying asset, the fund would theoretically suffer no loss. To help pay for this position, the fund then sells another call option, which creates the “cap” on the upside gains. The exact levels of protection and cap may differ from fund to fund. For example, Innovator offers funds with 9% and 15%, and 5% to 35%, downside protection in its main Buffer ETF series, as well as other variations. First Trust’s offerings 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 Ryan Issakainen, ETF strategist at First Trust, said buffer ETFs can work as a substitute for a traditional 60-40 portfolio, but this year, with bond yields soaring, buffer ETFs have become proven to be even more protective than this old-school strategy. Issakainen said the funds can also act as a counterbalance to riskier bets elsewhere for an investor. “They can pair a less volatile buffer ETF with 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 hold the underlying index, the funds do not follow the market perfectly even when they are between the zone buffer and the ceiling. Bond said the funds “rhyme the market” but generally see it lagging the market up and down before its set rebalancing period. Innovator offers funds for each month that hold positions for 12 months. “An option has a time value at the start, so it doesn’t move like the market. But the closer that option gets to expiration, the more market-like it is,” Bond said. This can cause funds to perform below expectations outside of their rebalancing periods. Morningstar Research Analyst Lan Anh Tran said that for investors to reap the advertised benefits of funds, it is best to buy them and hold them for their set periods. “The definite outcome comes with the expiration of the options. So if you can, hold it for the one-year holding period that a lot of these funds have, but if for some reason you have to pull out or if you change your mind, there’s no guarantee,” Tran said. The rebalancing period is also important because it can impact the upside potential remaining in a fund, with the rally in equities in recent months taking a bigger toll. large chunk of the cap for funds that entered into new options contracts near the bottom of the market.For example, the SPY has already breached the cap by about 2.4% of the super conservative BALT (Defined Wealth Shield) ETF. ‘Innovator, which rebalanced in July. However, a good thing for investors this year is that volatility makes the call option used to create the cap more valuable to the market. As a result, caps have increased The recently replenished August fund liberated (BAUG) has a potential net return of 21.66%, while the 11-month September (BSEP) fund can only return 12.11%. “It’s significantly higher than this time last year. I think the volatility is a good thing for those caps. When the market is volatile, the caps tend to go up,” Bond said.