As an investor, I am going to bet that you spend most of your time worrying about portfolio returns. For example, you probably ask questions like “Am I beating the S&P 500?”. Or, “Is there a better investment strategy I can use to make more money?”. What if I suggested that you need to think about it in another way? For example, with a risk lens similar to what an S&P 500 Buffer Protect Strategy Fund provides.
Stock Markets Go Down From Time to Time – Guaranteed
Each year, and sometime multiple times a year, the stock market has a drop of 10% or higher. Here is data from Covestor that shows the average frequency of market declines:
As an investor, you can expect to see a drop in the market of 5% or more approximately three times a year. A 10% drop about once a year and a 15% drop about once every two years.
These losses can be hard as big drops often lead to bad emotional decisions. It can be very tempting to sell when the market is down over 10% as you don’t want to lose any more money. The problem is that over time, the stock market ends up going up and you end up getting back all your paper losses if you didn’t sell.
Knowing that this volatility in the stock market exists, and your investment account value will go up and down with it, will help you prepare yourself mentally for how you’ll react once they do.
However, there are strategies you can employ in your portfolio that can help reduce the volatility. That is where a S&P 500 Buffer Protect Strategy fund comes in.
What is a S&P 500 Buffer Protect Strategy Fund?
The underlying purpose of a S&P 500 Buffer Protect Strategy Fund can be hard to wrap your head around at first. Intuitively it doesn’t make sense. Here is the simplest way to explain it:
A S&P 500 Buffer Protect Strategy Fund looks to provide downside protection for the S&P 500. With the fund, you are buying protection – or buffering the losses – against a drop of 10% or more in the S&P 500. In other words, the fund will not go down as much as the S&P 500 does during market declines. The cost of limiting your losses is that your gains will be capped at a pre-determined level.
Let’s look at a couple of different scenarios that highlight exactly how these funds work.
Scenario #1: The S&P 500 Decreases by 10% or Less
If the S&P 500 decreases by 10% or less, an S&P 500 Buffer Protect Strategy Fund will provide a total return of 0%. Even if the market down, but is only down 8%, your return will be still be 0%. In other words, you will not have lost any money even as the market heads lower. This image from CBOE Vest shows what I mean by this:
Scenario #2: The S&P 500 Decreases by More than 10%
This is where the real value of the Buffer Protect Strategy Funds shows up. If the S&P 500 goes down by more than 10%, then the fund’s return is 10% less than the percentage loss on the S&P 500.
In other words, if the S&P 500 is down by 15% (which we know happens about every two years), the the fund will only be down 5%. You are buffered against that bigger market drop. Similar to above, here is a visualization of what that protection looks like.
Scenario #3: The S&P 500 Goes up
You saw how a S&P 500 Buffer Protect Strategy Fund protects you when the market goes down in the last two scenarios. So what happens to your money invested in the fund if the S&P 500 goes up?
As with most things in life, there is no free lunch. The downside buffering you get from the fund comes at a cost. Instead of getting all of the gains from the market, the fund will only provide you with a return up to a specific amount, typically around 15%. (*Note: The upside protection depends on the fund you choose).
If the market is up 5%, then your return is 5%. However, if the market is up 27%, then you only will get a return of 15%. Your cost of that downside protection is the extra 12% up swing you did not get to participate in while holding the fund. Here is a visualization of that in action:
The Pros of a S&P 500 Buffer Protect Strategy Fund
Now that we have covered the what and how of a S&P 500 Buffer Protect Strategy Fund, let’s discuss the pros of using these funds in your portfolio.
Pro #1: Downside Protection
This is obvious, but the big benefit of these funds is the downside protection they offer. If you are worried about a big drop in the market then these funds are worth considering.
Pro #2: Helps You Stay the Course
The second benefit is that these funds help you stay the course by shielding you from those bad emotional reactions that happen when markets tank. If you know you have a habit of selling at the bottom of a market decline, these funds help. If you invest in these funds, your portfolio returns are smoothed out with limited troughs that often lead to selling at the exact wrong time.
The Cons of a S&P 500 Buffer Protect Strategy Fund
As always, there are disadvantages to these investment options.
Con #1: Limited Upside
By limiting your losses, you are also limiting the total portfolio growth you can achieve. As explained earlier, you are limiting the total growth of the fund. For example, if the fund has a growth cap of 15%, then that is the maximum gain you will get by holding this investment. Even if the market is up 27%, your gain will never be more than 15% in this fund.
Con #2: High Fees
The second disadvantage of these funds is they have higher fees than regular index funds available from companies like Vanguard or BlackRock iShares. Whereas you can get Vanguard funds for as low as 0.08%, the typical buffer protect strategy fund is around 1.51% (e.g. Fund Ticker: BUMGX). That is 1.51% of your return taken as a management fee by the fund, which can have a large impact on the future value of your portfolio.
Who Should Consider a S&P 500 Buffer Protect Strategy Fund?
These funds are not for everyone. Like all investment options, even a solid strategy like the Three Fund Portfolio, you need to consider how a strategy fits into your long-term investment goals. These types of funds can be used as part of a larger portfolio where downside protection is important.
For example, if you are a retiree who relies on your portfolio for income, you could consider using one of these funds to protect a specific percentage of your portfolio from dropping too much in a large market drawdown. You may also be a candidate for these funds if you are very prone to bad emotional reactions to market declines. If past history tells you that you always sell when things look really bad (which is the worst time!), then limiting your losses may be a good idea. Just know that you are also giving up some upside for that part of your portfolio.
In either of these cases, you should never put all of your portfolio in these funds. The risk of lower growth than the overall market is too high. If you are investing for the long term – at least five years – then just prepare yourself for the ups and downs of the market and hold on. Over longer time periods, the market has always gone up.
Would you consider using a S&P 500 Buffer Protect Strategy fund in your portfolio? Join the conversation in the comment section below.
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