Buffered ETFs Explained: The Real Costs Behind the “Protection”

Buffered ETFs promise to solve investing’s oldest problem: how to participate in market gains while avoiding market pain. The pitch is seductive. Downside protection with upside participation. But like most financial products that sound too good to be true, the reality is messier than the marketing.

The Basic Mechanics

A buffered ETF uses options to create a specific payoff structure, typically over a one-year period. If the underlying index (something like the S&P 500) falls, the fund absorbs the first portion of losses, say 10% to 15%. If the market rises, you capture gains up to a predetermined cap, perhaps 15% to 20%. Beyond that ceiling, your returns flatline no matter how high stocks climb.

The fund achieves this by buying put options to create the buffer and selling call options to create the cap. The premium collected from selling the calls helps pay for the puts. It’s financial engineering that transforms market exposure into something that looks safer, but isn’t necessarily better.

Basic illustration of 10% buffer and 15% cap solution.

The Timing Trap

The defined buffer and cap only work if you buy shares on day one of the outcome period and hold for that specific period. Most investors don’t. They buy and sell whenever it’s convenient, assuming they’re protected, but don’t read the fine print.

If you buy three months after the ETF resets and the market is already up 10%, your remaining upside might only be 5%. Meanwhile, your downside buffer may already be partially used or gone. You may be entering a moving vehicle and not know exactly where it is in the journey. The buffer erodes as the underlying index moves, and there’s no easy way to calculate your actual protection without diving into the fund’s options positions.

Here’s what else gets lost in the marketing: these funds typically exclude dividends from their protection and participation calculations. In a flat market year, you're already behind by roughly 2% just from missing dividend income. Add the typical higher expense ratios (often north of 0.8%) and you’re starting each year from behind.

The Odds

Consider what the actual trade-off is on a hypothetical 10% buffer with 15% cap.

From 1926 to 2024, the S&P 500 has returned more than 15% in 51 calendar years out of 99. That means you would have hit the cap and left gains behind nearly half the time.

Alternatively a 10% buffer would have only helped you in 14 of the 99 years, about 14% of the time. The other 34 years would be in between, but with a higher fee and no dividends.

Over time, missing those exceptional years typically costs more than the buffer saves during drawdowns.

S&P 500 Index 1926-2024. Red bars indicate calendar years where the index was over 15% (cap hurt you), green bars represent years where the index was below -10% (buffer helped you), and blue bars are years in between (neutral other than higher fees and no dividends in a Buffered ETF solution. ) Data Source: DFA ReturnsWeb

The Investor Behavior That Makes Them So Alluring

Buffered ETFs exist because people hate losing money more than they enjoy making it. Loss aversion is a powerful behavioral motivator and creates demand for products that promise to reduce the sting of market downturns, even when the math doesn’t support the trade-off.

Financial firms understand this. They’ve packaged loss aversion into a product with precise-sounding terms like “defined outcomes” and “structured protection.” But promises in marketing don’t guarantee promises in outcomes, especially when most investors use these products incorrectly.

A Simpler Alternative

Want downside protection? Hold cash or short-term bonds as part of your portfolio. Want upside participation? Own stocks directly. This boring approach gives you more transparency, lower costs, and fewer surprises.

If you absolutely need the psychological comfort of “protection,” make sure you understand what you’re buying. You’re paying around 0.8% annually for a hedge that only works under specific conditions, excludes dividend income, and caps your best years in exchange for cushioning your worst ones.

There may be behavioral value for some investors if it keeps them invested and prevents panic-selling. But that is often comfort at the price of a sound portfolio strategy.

What to Ask Yourself

Before buying any structured product, ask this: what am I giving up, and is it worth what I’m getting? With buffered ETFs, you're surrendering long-term return potential for short-term emotional comfort.

Buffered ETFs do not reduce risk. They just change its shape, hide it behind a cap, and charge you for it. At the end of the day, it is less risk management and more risk repackaging.

About the Author

Carson McLean, CFP® is the founder of Altruist Wealth Management, a flat-fee, fiduciary financial planning firm serving clients virtually across the country. With over 15 years of industry experience, Carson helps individuals and families make smarter financial decisions through transparent advice, evidence-based investing, and comprehensive planning. He’s on a mission to challenge outdated industry norms and help clients keep more of what they’ve earned.

Disclosure

This content is for informational and educational purposes only and should not be construed as personalized investment advice. Investing involves risk, including the potential loss of principal. Past performance is not indicative of future results. Always consult a qualified financial advisor before making decisions based on your unique financial situation.