Buffer Battle Escalates!

The starting point is a paper written in March by AQR that went after buffer and defined outcome funds pretty hard. Yesterday, I blogged about the latest response, there have been others, from Karan Sood who appears to be one of the inventors of the buffer fund concept. So when I wrote yesterday's post, I didn't know that AQR came back to the table to refute what I presume is Sood's arguments, Sood was never mentioned by name. Here's the link to yesterday's writeup from AQR. 

Read it all if you haven't already and are interested but I don't want to reiterate my general opinion about this type of product but in yesterday's AQR piece there was a line a reasoning that I do want to look at more closely and take issue with. 

If you click through to read the piece, I am talking about Section 4: Stocks Aren't The Right Benchmark, Bonds Are. Part of the argument AQR is refuting is that some (all?) of the buffer funds are better compared to bond funds, they should be thought of as bond substitutes. The Innovator Defined Wealth Shield ETF has the symbol BALT which they say stands for bond alternative. AQR's reasoning for this includes 

First, a benchmark should be related to the fund being benchmarked. This is why the benchmark for investment-grade bonds isn't commodities, and why the proper benchmark for hedge funds isn't 100% stocks. If a buffered fund is long stocks and options, why would bonds be a relevant benchmark? Why not stablecoins while we're at it?

I look at this much differently. Certainly a benchmark could be mismatched like they say about hedge funds and stocks but we look at proxies for asset classes all the time. Merger arbitrage for example can absolutely be a substitute or a proxy for certain parts of the bond market. Merger arb will have its own risks, it clearly is a different exposure versus buying bonds but it certainly functions as a fixed income replacement. Likewise with client and personal holding PPFIX. The strategy sells index puts that are very far out of the money. That is clearly a different exposure than bonds but trades just like certain segments of the fixed income market and again has its own risks that differ from fixed income. 

So does BALT function as a substitute for fixed income? The following backtest has 60% in an S&P 500 ETF and the other 40% in the fund listed in the name of the portfolio.

The stats for the BALT portfolio versus AGG and TLH are not that different. The TFLO version does differentiate. In 2022, the BALT version was down 9.90%, TFLO down 10.12%, AGG down 16.12% and TLH down 21.01%. BALT will have its own risks that will differ from regular fixed income exposure but there is something to the idea. I still think there are better ways to do this as I've been writing about for years but it seems reasonable that someone might want BALT and a bond alternative. To the AQR point, BALT is not intended to be a proxy for the equity market, it uses equities along with options to create an effect that differs (lags) from plain vanilla equities.

I am not converting to the buffer side of the argument but I think this is a better way to look at them. Almost all of them underperform plain vanilla equities. Ok their objective is not to keep up with plain vanilla equities. I think this is the correct way to look at them and then make a decision which for me is no. Whatever someone is trying to achieve with a buffer or defined outcome, I believe there are better, cheaper and simpler ways to do it. 

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