In its never-ending desire to create products that can be sold to investors, Wall Street has created buffer funds.

Formally known as defined-outcome funds, they appeal to investors who are concerned about incurring losses in downward-moving markets. Buffer funds limit the size of the potential loss to, or reduce it by, a preset percentage. Shareholders of these funds—they are mostly exchange-traded funds (ETFs)—know going in that they have some protection against losses.

Nothing on Wall Street is ever free. The potential gains on most defined-outcome funds are capped. If the returns of the benchmark (e.g., the S&P 500 index) exceed the cap, you miss the excess return. Even when there isn’t a cap, your upside return will be below the benchmark after the fund’s expenses are factored in.

Some of you might be thinking, “Wait, I’ve heard this song before.” Indexed universal life insurance policies have long offered a similar pitch. Their cash value is tied to an index with a buffer on how much you can lose and a cap on how much you can gain. These policies cost more than simple term life insurance policies. Buffer funds have higher expense ratios than plain-vanilla index funds too.

Cynthia McLaughin’s article in this issue explains how buffer funds work and critical terms you must understand before buying them: buffer, cap, floor and reset period. In addition to these terms, you will need to know whether the expense ratio is subtracted from the buffer or the cap.

Yes, the seemingly simple pitch of “your potential downside risk is limited” comes with much complexity behind it. As always, if you don’t fully understand an investment, grip your wallet tightly and walk away.

Alternatives to Buffer Funds

I prefer simplicity to unnecessary complexity. Investors are better served by more straightforward investments and allocating based on their timeline for taking withdrawals. Such an approach involves:

• Holding equities for long-term growth;
• Using cash or cash equivalents to cover short-term withdrawal needs; and
• Allocating to bonds or using bond ladders to reduce volatility and provide predictable cash flows.

Wishing you prosperity,