The Pros and Cons of Funds That Mute the Ups and Downs

Various types of exchange-traded funds aim to reduce stock market volatility; some work well, but there may be better ways to smooth returns

By Conrad de Aenlle

If the exaggerated swings of the stock market are getting you down, cheer up. An expanding array of exchange-traded funds and other tools can limit volatility — for a price.

In the last two years, several dozen so-called defined-outcome E.T.F.s, which blunt the impact of stock market declines by absorbing losses up to a point, have been introduced. To provide this protection, gains are limited, and the funds are intended to work best over a 12-month period.

Financial advisers and fund analysts say these E.T.F.s can be useful for managing swings in a stock portfolio. But they caution that there are limits to the funds’ effectiveness.

“If you’re building up a core position in a more risk-conscious way, these products are worth a look if your plan is to buy and hold them” for a full year, said Todd Rosenbluth, director of E.T.F. and mutual fund research at CFRA Research.

Here is how a defined-outcome fund works: Managers buy and sell combinations of derivative instruments, known as options, tied to the performance of a stock index like the S&P 500. These options allow the fund to limit any one-year loss in the index, while capturing some or occasionally all of any gain for the year.

After a year, the E.T.F. resets, with new option positions and gain caps. If market volatility is higher when the reset occurs, the cap will be higher, allowing shareholders to capture bigger gains, because volatility is a main component of an option’s price.

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