The Dispatch

Why did $2 billion flow into First Trust Buffer ETFs in 2023?

According to First Trust Advisors, in 2023 the firm saw nearly $2 billion of net flows into its flagship Target Outcome strategy, FT Cboe Vest Fund of Buffer ETFs (Ticker: BUFR)*. That is over half the total First Trust flows for the year into a single fund.

BUFR comprises 12 Target Outcome Buffer ETFs laddered monthly, with each providing a 10% downside “buffer,” while still capturing market upside limited by its individual cap, depending on how options are priced at the reset. The Buffer Ladder approach can be attractive for both tax non-qualified and qualified accounts since fund rebalancing is not expected to incur a taxable event as opposed to rebalancing individual buffer products within a client portfolio.

We believe that the major dynamics driving demand for hedged equity are coming from:

1. Nervousness over U.S. equity valuations given the strong run since the bottom of the global pandemic in the spring of 2020;
2. Recent memories of 20%+ drawdowns during the height of global shutdowns in early 2020 and throughout 2022.
3. Sharply higher interest rates in response to high inflation have hurt both equities and fixed income investments; and
4. Opportunistic positioning seeking to hedge downside risk while capturing more meaningful upside due to options skew (more on that below).

The S&P 500 Index has enjoyed a strong recovery over the post-pandemic period, returning a cumulative 99.30% (19.68% annualized) from 3/31/2020 through 1/31/2024, despite uncertainties of the macroeconomic and geopolitical environment. But most of the total return gain has been driven by earnings multiple expansion. As of 12/31/2023, the S&P 500 12-month forward price/earnings multiple has reached 20x, up sharply from 15x during the depths of the 2022 sell-off.

Some investors are becoming increasingly nervous about elevated market valuations, gripped by enthusiasm over business spending on generative artificial intelligence and cloud computing as exemplified by the outperformance of megacap technology stocks. Yet, not wanting to miss out on further gains, investors are opting for a middle ground of maintaining some exposure to the market through hedged equity strategies such as the First Trust Buffer series.

We also believe that driving the appeal for allocating to hedged equities is based on the increased attractiveness of using put options to hedge downside risk, especially out-of-the-money put options where there is very little demand to insure against significant downside losses.

Figure 1 displays the Nations Skew Index**, a gauge of investors’ willingness to assume downside risk via the difference in implied volatility between out-of-the-money versus at-the-money put options. A lower number indicates a greater willingness to assume downside risk by demanding less option premium for writing protection against sizeable negative market returns. As equity markets continue to advance, demand for downside protection has dropped to the lowest levels over the history of the index going back to 2013.

Figure 1 – Nations Skew Index (Demand for Protection Against Large Market Losses) Has Dropped to the Lowest Levels Since the Inception of the Index. 

The implication is that in the depressed environment for underwriting put options, you get more bang-for-your-buck purchasing insurance against market losses. Hence, the current Buffer ETFs offer greater upside market participation for a given level of protection against market losses. You may not be able to have your cake and eat it too, but the increased asset inflows suggest investors in Buffer ETFs are feeling they are getting pretty close.

To learn more about the defensive equity strategies available on the Freedom Advisors platform, please contact your Freedom Advisors consultant.