With trillions of dollars currently sitting in money market funds, many investors are asking: “Is there a better way to earn a return without the stomach-churning volatility of the stock market?”
A recent article from InvestmentNews highlights a growing trend: wealth managers are increasingly swapping “sideline cash” for hedged equity solutions, including buffered funds (also known as defined outcome ETFs). These funds track the price performance of an index like the S&P 500 but use options (often times on ETFs that track an index) to create a “cushion” against market losses in exchange for a capped upside.
To be clear, not all buffers are built the same. There are several iterations available today, such as funds that are designed to protect against the first 15% of market losses, and others that require you to feel the first 5% of “pain” but then provide a larger 30% buffer against the next leg down. There are even ultra-conservative versions with very limited upside that behave almost like a high-yield account.
For this post, we’ll focus on those that provide meaningful equity participation. But does that make them a replacement for cash? The answer depends entirely on the goal for those dollars.
When Cash is Actually “Scared Equity”
If your cash is what some call “dry powder” (money that you want to invest for the long term, but are too nervous to deploy because the market feels “too high”), then buffered funds may be an excellent alternative.
Many investors suffer from “entry paralysis.” They say, “I’ll buy in once the market drops 15%.” The problem is that while they wait for that 15% dip, the market often climbs, leaving them further behind. This may be helpful for a few reasons:
A “Synthetic” Buy the Dip: Buying a buffered fund at the start of an outcome period (i.e., with the full 12-month look-forward period ahead), indexed to a market which then declines, is in many ways like enacting a buy after the dip.
Overcoming Fear: It provides a built-in safety net. If the market correction you’re afraid of actually happens tomorrow, the buffer absorbs those initial losses. This allows “scared” cash to finally get to work and capture equity growth over the long run.
The “No”: When Cash is Meant to be Cash
If your cash is earmarked for a specific purpose, like a house down payment next year, a tax bill, or an emergency fund, a buffered fund is not a recommended replacement.
Risk of Buffered Funds vs. Risk-Free Nature of Cash: Cash in a high-yield savings account or money market is essentially risk-free (ignoring inflation and taxes). Buffered funds are still equity investments with downside risk, albeit reduced downside risk.
The “Tail Risk”: If the market drops 30% over a one-year period and you have a 15% buffer, you are still down roughly 15%. If you needed that money to buy a car or pay tuition, a 15% loss that you may never recoup is a significant problem. True cash doesn’t fluctuate; buffered funds do.
A Better Comparison? The New 60/40
At our firm, we are proponents of hedged equities (like buffered funds) because they allow clients to own more stocks and less bonds. We think this approach helps reduce the challenges we see with bonds, namely inflation protection and high taxation. Hedged equities as an alternative to bonds may help improve returns while maintaining a similar (or improved) risk profile.
It is important to be clear, though: a buffered fund is more akin to a 60/40 portfolio than it is to a bank account. In a traditional 60/40 portfolio, you use bonds to dampen the volatility of your stocks. With buffered funds, you are building that protection directly into the equity allocation. You get a similar “balanced” risk level, but you maintain higher equity exposure for the long term.
The Bottom Line
Use Buffered Funds if you have “long-term cash” that should be in the market but want some protection to get started. It’s a way to “buy the dip” before the dip even happens.
Keep the Cash if you need the money for a specific purchase or if you cannot afford any fluctuation in value.
Buffered funds are a powerful tool to help you stay invested without the full downside of the market over the buffered funds’ 12-month window, but they are a strategy for your investment portfolio, not your checkbook.
Disclosures
Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward looking statements cannot be guaranteed.
This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.
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