The limitations of downside mitigation ETFs

As global markets tumbled in 2022, with soaring inflation and geopolitical tensions sparking turmoil, investors saw portfolio values fall with seemingly no corner of the market spared from the volatility. Both domestic and international equities experienced a double-digit sell-off, and even U.S. bonds provided little shelter as this traditionally safe haven asset class experienced its worst year on record.

An untested innovation

Characteristic of the innovation that the exchange-traded fund (ETF) industry is known for, a category of funds has flourished in recent years, specifically designed to mitigate downside exposure whenever the next bear market arrived. The exact methodology used by these funds varies across issuer and product. Some of these funds, known as defined outcome or buffer ETFs, rely on options contracts to replicate index performance up to a certain cap. In exchange for this limit on upside performance, the ETF would help to manage market risk by buffering downside performance, either dampening losses up to a certain point or kicking in to protect against further losses after markets had dropped by a specified percentage.

Additional approaches employed by these downside mitigation ETFs include using options strategies such as a collar or put option overlay, while others supplement equity exposure with a strategic or tactical allocation to other securities such as Cboe Volatility Index futures or long-dated U.S. Treasury bonds.

As most of these ETFs had been developed in 2018 or after, they had yet to face a prolonged bear market that would test their mettle. This didn’t deter investors, with category assets growing even as market valuations soared. As markets fell in 2022, assets within these ETFs doubled as investors tried to take cover.

So how did these ETFs fare when put to the test? A recent analysis found that half of these ETFs failed to outperform an ETF that tracked the S&P 500 Index, which lost 18.2% for the year. Further, three of these ETFs even notched losses that were substantially greater, falling by more than 25.0%. 

You can't time the market

For downside mitigation ETFs that were able to outperform the broad equity market ETF, longer-term performance highlights a potential pitfall of allocating to these types of funds.

Investors who added a downside mitigation ETF into their portfolio from 2018 to 2021 were doing so as an insurance policy: They wanted to protect against future market losses though the exact timing of when this would occur was uncertain. However, this insurance—even if it worked—came with a price tag in the form of limited upside.

The longer one of these downside mitigation ETFs is held within a portfolio before a market drawdown, the more potential upside is given up by the investor. This helps to explain why the analysis showed that many of these ETFs underperformed the broad market ETF over the trailing two- and three-year time periods, even if they outperformed in 2022. And with markets off to a strong start in the first half of 2023, investors who have held on to these ETFs are likely lagging the market once again. While many of these ETFs are too new to have a track record of any significant length, we expect that these funds will underperform the broad market over the long term.

On the other hand, strong flows into the category throughout 2022 provide evidence that for some investors an allocation to these downside mitigation ETFs might have come after at least some part of the market drawdown had already been incurred, limiting their effectiveness. As these points demonstrate, investors’ experience will be highly dependent on how well their purchase is timed, which we see as a significant risk to investors that allocate to these downside mitigation ETFs.

A time-tested approach

Instead of trying to time the next market downturn, we believe that investors can outperform over the long term by investing in a multifactor strategy, an approach that is rooted in decades of academic and empirical research.

A landmark 1992 study by Eugene Fama and Kenneth French identified two factors that may improve a portfolio’s expected return, now known as the small-cap premium and the value premium.¹ Further research by Robert Novy-Marx identified profitability as a third factor that can enhance expected returns.

While factors aren’t immune to market timing, with certain factors falling in and out of favor, combining them into a multifactor strategy works in a similar way to portfolio diversification. Building a portfolio with exposure to multiple factors helps to ensure that at least one factor will be working at any given time.

Like downside mitigation ETFs, multifactor ETFs can be used in multiple ways—either as a core holding or to diversify or complement other existing holdings within the portfolio. In contrast, investors don’t need to worry about buying or selling a multifactor strategy at a specific time in the market cycle.

By remaining invested in a multifactor strategy over time, investors can avoid the many pitfalls of downside mitigation ETFs and receive the potential benefit of higher expected returns with no limit to the level of upside participation. In our view, staying invested while tilting portfolios toward factors that have been proven to drive expected returns should result in better investor outcomes over time. 

1  A premium represents the excess return that securities with particular characteristics have historically generated. The chart above shows historical geometric mean performance for different groupings of stocks within the broad equity universe. This universe, or market, includes stocks listed on the NYSE, AMEX, and NASDAQ exchanges. The research does not portray results of indexes. In order to assess returns of stocks with different characteristics, researchers Eugene Fama and Kenneth French grouped stocks according to size, relative price, and profitability. For groupings based on company size, stocks were ranked by market capitalization, where small cap represents stocks of companies in the bottom 30% of the universe and large cap represents stocks of companies in the top 30% of the universe. For groupings based on relative price, stocks were ranked by book-to-market equity ratios, where value represents stocks of companies in the top 30% of the universe and growth represents stocks of companies in the bottom 30% of the universe. For groupings based on profitability, stocks were ranked by operating profitability (annual revenues minus the cost of goods sold, interest expense, and selling, general, and administrative expenses, divided by book equity), where high profitability represents stocks of companies in the top 30% of the universe and low profitability represents stocks of companies in the bottom 30% of the universe. Drs. Fama and French are members of the Board of Directors of the general partner and provide consulting services to Dimensional Fund Advisors LP. Diversification does not guarantee a profit or eliminate the risk of a loss. Selection of other periods may produce different results, including losses. Past performance does not guarantee future results.