The Risk of Buffer and Floor Strategies
Investment strategies that use buffers and floors to provide downside protection, such as registered index-linked annuities (RILAs) and a growing number of ETFs, are gathering assets and receiving a significant amount of attention in the media and among advisors. But their risk is harder to measure than more traditional investment products. While their returns are going to be based on their underlying index (typically the S&P 500), the realized returns will vary significantly depending on the put and call option exposures used to implement the strategy.
In this article, I provide guidance on the “equity-like” risk of buffer and floor strategies when included in a diversified portfolio, assuming an S&P 500 underlying index. I use four measures of risk: standard deviation, downside risk, value-at-risk and conditional value-at-risk.
This research attempts to quantify the extent to which each product would be considered “equity-like.” Risk is framed in terms of equity exposure since it is a generally accessible metric and normalizes the results across the risk metrics I consider.
This analysis shows that the risks of buffer and floor strategies differ significantly by approach and level. To generalize, the equity-like risk of buffer strategies can be approximated by taking 100 minus four times the buffer level and the equity-like risk of floors can be approximated by multiplying the floor level by four. For example, a 10% buffer product would be approximately 60% equity-like (100-(4*10)=60) and a 10% floor product would be approximately 40% equity-like (10*4=40). These are approximations that don’t capture the more complex risk considerations associated with different product combinations (e.g., a 30% buffer floor has a much greater potential loss than a 10% equity allocation),but provides a useful rule of thumb to advisors.
What are buffers and floors?
Investors want full upside participation with no potential for loss. While this isn’t a realistic goal, it is possible to implement a strategy with some upside potential that limits downside risk by using options such as puts and calls. A fixed indexed annuity (FIA) is an example of such a product, as are more traditional structured products.