Protecting Your Portfolio from Market Downturns with Buffer ETFs

As the saying goes, it only takes a spark to light a fire. Just days after the Federal Open Markets Committee (FOMC) issued a policy statement to hold interest rates steady amid recent indicators suggesting economic activity is still growing at a solid pace, the release of the July 2024 jobs report upended market sentiment as U.S. employers added just 114,000 jobs in July — 35% fewer than expected — and unemployment, now at 4.3%, is the highest it has been since October 2021.

As unemployment has risen, the dominant narrative has become that a recession is inevitable, with many market commentators citing Sahm’s rule as the basis for recession fears. Ironically, Claudia Sahm, the economist for whom the rule is named, wrote in a recent post that “a recession is not inevitable, but the risk of a recession has increased.”

The domino effect of the Bank of Japan’s actions

While the jobs report changed market sentiment on Friday, the Bank of Japan’s latest move to raise its benchmark interest rate from 0.10% to 0.25% prompted a drop in U.S. stock markets on Monday. How was that possible? Because of the yen’s carry trade.

Macroeconomic conditions between Japan and the United States have changed. Since the beginning of 2023, the Federal Reserve has raised interest rates while the Bank of Japan has kept its rates close to zero. This difference has made the yen less attractive, allowing investors to borrow cheaply in yen and invest in higher-yielding assets such as U.S. stocks, particularly the Magnificent Seven.

This practice, known as carry trading, further devalued the yen. The weaker yen boosted profits for export-oriented Japanese companies, as their overseas earnings became more valuable in yen terms.

With the Bank of Japan implementing tighter monetary policy, investors are forced to close their positions due to the appreciation of the yen, causing the market to fall sharply. The Japanese stock market was particularly affected, led by export-oriented companies, as they benefited from the weaker yen through both competitive pricing and higher reported earnings abroad. The Nikkei 225 lost much of its value on Monday, reaching a multi-decadal high of 42,426 on July 10.

Withdrawals are possible but can be managed

The market activity on August 2 and 5 is an example of a simple investing fact: the market is falling. While the impetus for this decline was the widespread belief in a recession and a change in Bank of Japan policy, the event itself (i.e. the market decline) is part of the normal stock market cycle. This is illustrated in the chart below, which shows the historical declines of the S&P 500 since 1989.

Buffer ETFs: A Risk-Managed Approach to Investing

For those looking to manage volatility and protect their investments from significant market declines, buffer ETFs offer a more predictable return by limiting drawdowns and capping upside potential over a set period (usually one year).

These funds are particularly attractive to more risk-averse investors, as they may not want to take on additional risk in their portfolios. The investment performance of buffer ETFs that use BMO US Equity Buffer Hedged to CAD ETF – October (short: ZOCT) as a point of reference, this was demonstrated during the last drawdown.

Investors should note that the performance of buffer ETFs depends on factors such as the timing of your investment (it is best to start investing at the beginning of the buffer period) and the size of the buffer, which provides greater protection but may limit returns.

To go

Market declines are a natural part of investing and should be expected. However, buffer ETFs can be used as a mitigating measure for investors who want to manage their exposure to losses during such events.

For investors interested in buffer ETFs, BMO ETF has launched its first buffer ETF and in just a few months has gradually expanded its investment offering in this product category, recently introducing BMO US Equity Buffer Hedged to CAD ETF – July (short: ZJUL).

BMO’s Buffer ETF provides investors with exposure to the large-cap segment of the U.S. stock market, namely the S&P 500 Hedged to Canadian Dollars Index, while providing a buffer against the first 15% decline in the index’s market price over a period of approximately one year.

Read more: How BMO Buffer ETFs Can Protect Your Portfolio in Volatile Markets

Please note that this article is for informational purposes only and does not in any way constitute investment advice. Before making any investment decisions, it is essential that you seek advice from a registered financial professional.