The View from the Hill--Perspectives on Markets and Strategies

Buffer Protection Strategies - Managing Over Time
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Mutual funds and exchange-traded funds (ETFs) that seek to limit downside participation for a range of downside index exposures have been available for several years now. These products give investors a choice of strategies that focus on hedges that expire and roll in a particular calendar month utilizing exchange-traded FLEX index options. Additionally, there is a mutual fund that diversifies across calendar-month strategies for investors looking for more of an ongoing risk management approach. Using the history of Target Outcome Buffer Protect Index returns, we compare select strategies for managing buffer protection strategies over longer investment horizons.

Cboe introduced the Target Outcome Buffer Protect Index Series in April 2016 based on a concept and methodology created by Cboe Vest. This index series serves as a benchmark for buffer mutual funds and ETFs that incorporate downside protection strategies for the S&P 500 with a 12-month term, with cost of protection financed by the sale of a call option capping upside price returns at a level sufficient to fund the put spread options that hedge the first 10% of downside returns. The entire Cboe S&P 500 Buffer Protect Index series has benchmarks for each calendar month (tickers: SPRO1, SPRO2, SPRO3, etc., to SPRO12), representing the month of the year when the initial 12-month buffer protection strategy is set up and rolled into the next 12-month series. The Cboe S&P 500 Buffer Protect Index Balanced Series (ticker: SPRO) tracks the returns of a composite, laddered portfolio of all 12 of these indexes that roll out to a new 12-month S&P 500  buffer protection strategy in a specific calendar month.

In addition to an index-based buffer mutual fund that diversifies buffer protection strategies equally across all 12 calendar months, ETFs have also become available in the last two years that have a specific calendar-month rolling strategy, with the roll month designated in their tickers.  These offer downside protection for S&P 500 ranges of 0% to -10%, as well as other ranges, in some cases starting at -5% and buffering a larger range of downside return.   An investor can combine or sequence these ETFs as needed, based on their market outlook and investment horizon. Given these choices for implementing buffer protection strategies, we can compare index performance features across particular calendar-month protection strategies along with indexes like SPRO that diversify across time horizons. Since the Cboe 0% to -10% Target Outcome Buffer Protect Index Series has a four-year live track record, it can be used to provide some insights into the return and risk of these types of risk management strategies.

Buffer Protection Strategies and S&P 500 Declines—Looking Backward and Forward 

The last four years have been unusual ones in terms of S&P 500 returns. Aside from a modest -0.76% return in the quarter ending March 2018, the S&P 500 has had only two down quarters, but they have been extreme: -13.52% in Q4 2018, and -19.60% in Q1 2020. The SPRO index, representing the balanced series of 12 calendar-month buffer protection strategies, outperformed the S&P 500 by 5.42% in Q4 2018 and 6.15% in Q1 2020. The interplay between a specific period’s S&P 500 return and a rolled buffer protection strategy is key to understanding how to structure these strategies.

The challenge is that investors generally employ these risk management strategies to reduce downside equity market participation without knowing the timing or degree of forthcoming downside equity index moves. Yet, buffer protection strategies have a specific range and term of protection (e.g., 0% to -10% for 12 months). The 0% to -10% buffer range and upside cap, in terms of index points, are reset at the end of each 12-month period. These specific term buffer protection strategies have a varying amount of downside protection over the year, depending on where the index is relative to the fixed protection range and term. However, they do offer less sensitivity to downside moves on an ongoing basis.

The “beta” of an index or structured strategy relative to the S&P 500 provides insight into the extent of index exposure risk, on average. Buffer protect strategies tend to produce asymmetric return profiles with upside caps and lower participation in a specific range of downside returns in the month they are rolled forward. However, monthly return betas can still provide insights into the ongoing risk profile of the strategy relative to the S&P 500. Historical analysis of the monthly returns between April 2016 and June 2020 for Cboe’s Target Outcome Buffer Protect Indexes SPRO2 and SPRO8 indicates their betas have been 0.66 and 0.64, respectively. The beta for the SPRO Balanced Index, which diversifies across buffer protect strategies that roll in the calendar months, was 0.62. Therefore, by switching from S&P 500 exposure into a 0% to -10% S&P 500 buffer protection strategy, the investor is reducing equity risk over time by approximately 35% to 40%.

Comparing 0% to -10% Buffer Strategies: A Look at Quarterly Returns, Q2 2016 to Q1 2020

We analyze quarterly returns of the Target Outcome Buffer Protect Index Series to compare how strategies that roll in two specific calendar months have performed versus approaches that combine calendar-month strategies. In our example, we look at the 16 quarterly returns for the February and August buffer protection series, SPRO2 and SPRO8, along with the returns for the SPRO index that diversifies across all 12 calendar months and implicitly rolls the expiring position each month. We also analyze a strategy that switches between holding SPRO2 and SPRO8, semiannually at the end of June and December. This strategy is designed to always have downside buffers that range between approximately two and eight months to expiration, so that the investor gets the benefit of a short-term protection strategy on an ongoing basis.


Comparison of S&P 500 -10% Buffer Protection Strategy Indexes

Quarterly Returns, Q2 2016 – Q2 2020

Source: Cboe and Bloomberg.


Comparison of S&P 500 -10% Buffer Protection Strategy Indexes

Average and Worst Quarterly Returns, Q2 2016 – Q2 2020

  SPRO2 SPRO8 Roll Semi-Annual SPRO S&P 500
Average (Q2 2016 to Q2 2020) 1.91% 2.14% 2.22% 2.11% 3.35%
Q4 2018 -8.10% -9.59% -8.10% -8.04% -13.52%
Q1 2020 -15.68% -13.45% -13.45% -13.47% -19.60%

Source: Cboe and Bloomberg.

The quarterly returns in the chart show that there are slight differences between the four different buffer protection strategies. The biggest differences are between strategies that select a specific calendar month to roll positions: SPRO2 (February) and SPRO8 (August) indexes had average quarterly returns of 1.91% and 2.14%, respectively. In some quarters, such as Q1 2017 and Q1 2019, the August Series (SPRO8) outperforms. But in other quarters, such as Q4 2018, the February series (SPRO2) has higher returns, in large part because it is closer to expiration and more sensitive to the market decline.  In the most recent down quarter, Q1 2020, the S&P 500 Index decline came after the SPRO2 index had rolled out to a strategy that expires in February 2021, so this buffer protect index did the poorest job of managing the downside risk of the indexes and strategies.

Over the more than four-year period, SPRO had average quarterly returns of 2.11%, or 63% of the 3.35% S&P 500 average quarterly performance—consistent with its beta. The SPRO index strategy diversifies the timing risk, since it holds 12 positions representing each calendar month and the associated 12 different 0% to -10% protection ranges in terms of S&P 500 levels. In the table above, we show the index performance for the two worst-performance S&P 500 quarters since April 2016. The SPRO returns compare favorably in these two extreme downside quarters. The strategy that rolls semiannually between SPRO2 and SPRO8 to keep a near-term buffer strategy in place has the highest average quarterly return of 2.22%. It illustrates the performance features of an ongoing shorter-horizon buffer protection strategy that has a bit higher sensitivity to downside S&P 500 Index moves.

Conclusion: A Range of Choices for Strategic and Tactical Equity Risk Management

The Cboe Target Outcome Buffer Protect Index Series provides a return history to compare alternatives available for managing downside risk with a buffer range of 0% to -10% rolled once a year.  Investors can choose a fund that rolls in a particular calendar month where they think the risk of an S&P 500 decline is the highest, or use a fund benchmarked to a ladder-type index like SPRO that diversifies positions across all months. Alternatively, investors can shift over time between different calendar-month ETFs or hold them in combination to seek to earn more consistent returns regardless of the time of the year when downside risk occurs.

In all cases, the buffer strategies with 12-month protection covering a 0% to -10% range have reduced risk to approximately 60% of that of the S&P 500 over the last four years. The downside performance results vary the most for specific calendar-month index strategies. This is because the pattern and timing of index declines impact their performance to a greater extent compared to a longer-term approach that diversifies positions across months or uses a rule for shifting indexes semiannually to provide a more consistent time frame for the hedge. These results suggest investors who do not have a particular market view or specific target horizon should use a diversified approach to buffer protection. They can do this by holding a mix of available ETFs or using a mutual fund benchmarked to a laddered strategy of calendar-month buffer protection strategies.