The Hidden Risks of Laddered Buffered ETFs and Structured Notes

THE HIDDEN RISKS OF LADDERED BUFFERED ETFs & STRUCTURED NOTES

Investors often turn to buffered products — such as structured notes or buffered ETFs linked to the S&P 500 — with the expectation that irrespective of market fluctuations, the initial terms will be honored at the end of the outcome period. These instruments aim to provide downside protection while allowing for capped upside potential. However, when these products are incorporated into a laddered portfolio, several challenges emerge that can undermine their intended benefits.

THE ISSUE OF EMBEDDED GAINS

In a rising S&P 500 market, each tranche within a laddered structure accumulates gains over time. While these gains reflect market appreciation, they can erode the downside protection central to the strategy. This situation is akin to purchasing a buffered ETF well after its inception; by that time, the market may have appreciated, exposing the investor to potential losses if the market declines. In a laddered portfolio, this issue is magnified across multiple tranches, each with varying levels of embedded gains. A market downturn can erase these gains, exposing the portfolio to greater losses than initially anticipated. Consequently, the strategy's effectiveness becomes dependent on precise market timing for both entry and exit, which contradicts the fundamental appeal of outcome-oriented investments designed to offer predictable results over a set period.

CHALLENGES INTRODUCED BY LADDERED STRATEGIES

Outcome-oriented products are crafted to establish and meet clear expectations. However, adopting a laddered approach with structured notes or buffered ETFs introduces significant timing risks, making it challenging to determine optimal entry and exit points. Over time, this approach can begin to resemble a hedged equity strategy with a capped upside, diluting the original value proposition of these products.

Source: Bloomberg, YCharts

KEY ISSUES WITH LADDERED BUFFERED ETFs & STRUCTURED NOTES

1. Loss of Defined Outcome Certainty: A single buffered product held to maturity offers a clear outcome. In contrast, a laddered portfolio comprises multiple tranches with varying levels of embedded gains, leading to inconsistent downside risk and making the investment's protective features less predictable.
2. Dilution of Core Strategy: As the S&P 500 rises, newer tranches may still offer protection, but older tranches lose effectiveness due to accumulated gains. This results in uneven risk exposure that depends on market conditions at the time of entry.
3. Market Dependency: Buffered products are designed to provide structured risk/reward over a fixed period. However, laddering forces investors into market timing decisions — both when initiating and unwinding positions — defeating the purpose of a set outcome period.
4. Capped Upside with Increasing Risk: Over time, a laddered strategy begins to resemble a hedged equity strategy rather than a defined outcome investment. While hedged equity approaches have merit, they lack the clear risk/reward profile that structured notes and buffered ETFs are meant to provide.
5. Eroded Downside Buffers: Depending on market movements, some tranches within a laddered portfolio may have fully passed through their downside buffers, leaving investors exposed to unlimited loss potential in certain parts of the portfolio.

CONCLUSION

At first glance, a laddered approach to structured notes or buffered ETFs may seem like a strategy to manage risk and smooth returns over time. However, the accumulation of embedded gains, increased reliance on market timing, and erosion of downside protection can dilute the fundamental value of these products. Instead of offering a predictable outcome, laddering introduces complexity and risk exposure that may leave investors unprotected at critical moments.

For those seeking true outcome-oriented strategies, a single-tranche approach with clear start and end dates may more effectively achieve the intended risk/reward profile. Otherwise, laddering transforms these structured investments into timing-dependent strategies with uncertain results.

This decisive action by the Fed to reduce rates after a massive rate-hiking cycle may have been a bit premature, given that this move could spark a resurgence of inflation. Ironically, by the time the Fed finally reduced the Fed funds rate, interest rates had already bottomed and started to move upwards yet again after the cut. This rebound in rates highlights the market’s concern with the prospects for a re-acceleration in the rate of inflation. Interest rates responded accordingly with the same 10-year rate rising from the September lows to close the year at 4.58% in spite of two additional 0.25% rate cuts, putting a damper on investment grade bond returns for the quarter and the full year. As measured by the Bloomberg Barclay’s U.S. Aggregate Bond Index, bonds produced a total return of -3.06% for the 4th quarter and 1.25% for the full year.

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