The buffer fund mirage: why simple beats complex for downside protection

New research from AQR Capital Management challenges the marketing claims behind buffer funds, revealing that these intricate products consistently lag straightforward combinations of stocks and cash whilst failing to deliver reliable downside protection.

You've heard this story before in different disguise. A revolutionary insurance policy for your home promises to cover exactly the damage you fear most, but only during specific hours of specific days. Outside those windows, you're unprotected. When disaster strikes at 3:17 AM on a Tuesday, you discover your premium payments bought nothing but false reassurance.

Buffer funds promise equity returns with downside protection, but the latest academic research reveals they deliver something else entirely: the investment equivalent of that worthless insurance policy. These fast-growing products fail when investors need them most, whilst extracting higher fees than the straightforward solutions that consistently outperform them.

Rigorous research exposes the buffer fund reality

A comprehensive new study published in The Journal of Portfolio Management provides the most thorough analysis yet of whether buffer funds deliver on their promises. Cliff Asness, Jeffrey Cao, Antti Ilmanen, and Dan Villalon from AQR Capital Management set out to test buffer fund marketing claims against hard empirical evidence—and their findings should concern anyone considering these products.

The researchers analysed 401 defined outcome funds with at least 24 months of operating history, representing the entire universe of buffer products available to investors as of May 2025. Their methodology compared fund performance against stated reference assets over multiple time horizons, evaluated risk-adjusted returns using Sharpe ratios, and tested protection effectiveness during actual market drawdowns.

Most crucially, they examined whether payoff diagrams accurately reflect investor experience. This investigation matters because marketing materials emphasise theoretical protection scenarios that may not represent real-world outcomes. The authors specifically tested performance during the three largest S&P 500 drawdowns since 2020: the COVID-19 crash, 2022's inflation-driven decline, and 2025's policy uncertainty period.

Their findings systematically demolish buffer fund marketing claims. The research demonstrates that these products deliver inferior risk-adjusted returns, fail to provide reliable downside protection, and lag simple stock-cash combinations during precisely the market stress periods they're designed to navigate.

The buffer fund boom built on shaky foundations

The defined outcome industry represents one of asset management's fastest growth stories, exploding from zero to £65 billion in assets under management since 2016. These products emerged as index-based mutual funds in 2016 and exchange-traded funds in 2018, making complex option strategies accessible to retail investors for the first time.

Buffer funds dominate this space, accounting for 360 of the 401 products analysed. They promise equity market exposure with some downside protection through sophisticated option combinations that modify return distributions. The appeal proves particularly strong among retirees seeking reduced volatility without abandoning growth potential entirely.

The median expense ratio of 0.79% reflects the premium investors pay for this perceived sophistication. Marketing materials emphasise customised protection levels—typically 9-15% buffers — combined with capped upside participation that theoretically provides equity-like returns with reduced downside risk.

However, this growth occurred during a period when rigorous performance analysis remained limited due to short track records. The AQR study represents the first comprehensive academic examination of whether these products deliver promised benefits or simply extract fees through complexity that doesn't improve investor outcomes.

How buffer funds actually work

The researchers explain that buffer funds typically employ four European-style options contracts against the same reference asset. Fund managers go long a deep in-the-money call option (providing near-complete equity exposure), purchase an at-the-money put option (creating the buffer), sell an out-of-the-money put option (establishing the buffer limit), and sell an out-of-the-money call option (capping upside gains).

This structure creates the characteristic kinked payoff profile that marketing diagrams emphasise. The design aims to protect against initial losses — typically the first 10-15% — whilst preserving most upside participation until reaching predetermined caps. The sold call option effectively finances the protective put options, making the strategy appear cost-neutral at inception.

Critical design statistics reveal investor preferences and structural limitations. The research shows 89% by number and 98% by assets are capped, confirming that investors accept limited upside for perceived downside protection. However, only 15% by number and 4.7% by assets provide complete protection, meaning most products protect within rather than beyond loss thresholds.

This design choice proves significant because it trades away protection from catastrophic losses—the very scenario that keeps many investors awake at night. Instead of guarding against true disasters, buffer funds protect against moderate declines whilst leaving investors exposed to severe market disruption.

The performance reality demolishes marketing claims

The AQR research delivers devastating findings about buffer fund performance. The average and median buffer fund delivered risk-adjusted returns inferior to reference assets, contradicting the fundamental value proposition that customised payoffs improve investor outcomes.

The performance deterioration follows a predictable pattern that reflects structural disadvantages rather than temporary setbacks. Funds with longer track records perform worse than those with shorter histories, suggesting that initial positive results represent statistical noise rather than genuine skill or structural advantages.

Specifically, the median fund demonstrates a Sharpe ratio disadvantage of -0.07 compared to its reference asset. This gap widens over time as three negative return sources compound: volatility risk premium costs, transaction expenses from option trading, and elevated management fees compared to passive alternatives.

The authors describe buffer fund returns as bundling "the expected return of the reference asset, the negative expected return of being long the volatility risk premium, the negative expected return from transactions costs of trading the options, and the negative expected return from higher management fees."

This mathematical framework explains why these products persistently disappoint. They face structural headwinds that simple equity-cash combinations avoid entirely.

When promised protection evaporates

The study's most damning findings concern protection effectiveness during actual market stress. Buffer funds significantly lagged beta-matched stock-cash portfolios during all three major drawdowns analysed, delivering average trailing performance of 0.8% across these critical periods.

During the COVID-19 crash (February-March 2020), more than 80% of buffer funds delivered inferior results compared to straightforward reference asset-cash combinations. The median fund lagged by 1.2%, whilst some trailed by over 25%. Similar patterns emerged during 2022's inflation-driven volatility and 2025's policy uncertainty.

The research reveals why payoff diagrams mislead investors about real-world experience. These charts accurately describe outcomes only for investors who buy on specific option initiation dates and hold until exact expiry dates — typically the third Wednesday of particular months. For any other timeframe, actual results diverge dramatically from theoretical protection.

Analysis of rolling annual returns starting on any day of the year shows that 75% of observations for 9% buffer funds fall below the protected level when reference assets perform within the supposedly safe zone. When markets breach buffer thresholds entirely, 84-87% of observations deliver worse outcomes than implied by marketing materials.

How this research fits the broader evidence

The AQR findings align perfectly with decades of academic research on structured products and options-based strategies. The authors explicitly place buffer funds "in the broader lineage of structured products" that have consistently disappointed investors despite sophisticated marketing.

Previous research on structured products demonstrated similar patterns of underperformance. Studies of Stock Participation Accreting Redemption Quarterly-pay Securities (SPARQS) and yield enhancement products found embedded fees large enough to generate negative expected returns even before considering implementation challenges.

The buffer fund evidence extends this disappointing tradition. Like their predecessors, these products combine appealing theoretical benefits with persistent practical failures. The research confirms that "much of the innovation in this space is superficial, engineered more for sales than for substance."

Historical analysis of Cboe protective put indices (PPUT and PPUT3M) provides additional context. These benchmarks demonstrate the long-term cost of being long volatility through put options, showing consistent trailing of simple equity exposure over multiple decades.

Buffer funds face identical structural challenges whilst adding complexity that compounds disadvantages.

The authors conclude that "once again Robert Heinlein, and his TANSTAAFL [There Ain't No Such Thing As A Free Lunch], is a better investment manager than the industry." This reference highlights how fundamental economic principles predict buffer fund failures regardless of marketing sophistication.

What Consumer Duty means for structured product sales

Under the FCA's Consumer Duty regulations, providers must demonstrate that complex products deliver good outcomes for retail clients. The AQR evidence suggests buffer funds may struggle to meet this standard when performance gets properly scrutinised against simpler alternatives.

Consumer Duty requires clear disclosure of costs, risks, and limitations that buffer fund marketing materials often obscure. The complexity of four-option structures makes it genuinely difficult for retail investors to understand what they're buying, potentially violating the duty to enable informed decision-making.

For UK investors using ISA or pension wrappers, buffer products present additional complications. The elevated costs compound within tax-advantaged accounts, whilst supposed tax efficiency benefits often prove overstated compared to straightforward index fund approaches that achieve similar risk levels at lower expense.

Platform providers may face difficult questions about whether recommending buffer funds serves client interests when evidence shows cheaper alternatives delivering superior outcomes. The gap between marketing claims and empirical results creates potential Consumer Duty compliance risks for firms promoting these products to retail investors.

The straightforward alternative consistently wins

The research validates what cost-conscious investors have long suspected: simple approaches outperform expensive complexity. Beta-matched combinations of reference assets and cash delivered superior results across all major market stress periods whilst providing complete transparency about holdings and costs.

Want 70% equity exposure with 30% protection? The evidence shows you'll achieve better outcomes buying 70% global equity index funds and holding 30% in cash or short-term government bonds rather than purchasing buffer products promising equivalent risk levels.

This direct approach eliminates exposure to volatility risk premiums that drag buffer fund returns. You avoid transaction costs from complex option trading whilst paying minimal fees compared to structured alternatives. Most importantly, protection functions continuously rather than only during arbitrary calendar windows.

The cost differential proves substantial over time. Buffer funds' median 0.79% annual charge compared to perhaps 0.15% for equivalent index fund exposure means paying an extra 0.64% annually for inferior outcomes. On a £100,000 investment, this compounds to approximately £15,000 in additional costs over 20 years — money that buys worse performance and unreliable protection.

Why innovation often disappoints investors

The AQR research places buffer funds within the established pattern of financial product innovation that serves industry interests rather than investor welfare. Complex products generate higher profit margins through elevated fees whilst often delivering inferior outcomes compared to transparent alternatives.

Academic analysis consistently reveals this pattern across decades and product categories. Structured notes, principal-protected bonds, variable annuities, and now buffer funds follow identical scripts: sophisticated marketing materials emphasising theoretical benefits, initial enthusiasm from investors seeking solutions to market volatility, and eventual disappointment when performance fails to match promises.

Buffer funds represent particularly clever marketing because they address genuine investor concerns about downside risk whilst appearing to solve the problem through quantified protection levels. The precision of "10% buffer" or "15% buffer" creates an illusion of scientific design that obscures fundamental structural disadvantages.

The evidence suggests holding new products to higher evidential standards rather than accepting clever diagrams as proof of effectiveness. Innovation should demonstrate improved investor outcomes through rigorous performance analysis, not just theoretical appeal or marketing sophistication.

A rational alternative

Based on this research, here's a better strategy than buying buffer products:

1. Calculate your genuine risk tolerance: Determine the maximum portfolio decline you can accept without panic selling (be honest—most people overestimate their tolerance during actual market stress)

2. Set transparent allocations: If 20% decline represents your limit, use 80% global equity index funds and 20% cash or short-term government bonds—no complex mechanics required

3. Choose low-cost, transparent vehicles: Use broad market index funds with annual costs below 0.15% rather than structured products charging 0.79% for inferior results

4. Ignore sophisticated protection marketing: Complex payoff diagrams and protection promises consistently fail precisely when you need them most, according to empirical evidence

5. Implement continuous protection: Unlike buffer funds' arbitrary protection windows, simple allocation adjustments provide constant downside management that works regardless of timing

6. Prepare psychologically for volatility: Accept that genuine protection means lower returns during bull markets—this represents the authentic price of reduced anxiety during bear markets

7. Review allocation annually only: Assess positioning once per year or during major life changes, avoiding constant tinkering that research shows destroys long-term outcomes

The AQR study provides definitive evidence supporting simplicity over complexity for downside protection. Their rigorous analysis of 401 funds demonstrates that paying premium fees for sophisticated option strategies delivers inferior outcomes compared to transparent, low-cost alternatives that you can understand and control directly.

This article is for information only and does not constitute financial advice. Your capital is at risk when investing. Past performance does not guarantee future results. Always do your own research or consult a regulated financial adviser before making investment decisions.

Reference

Asness, C., Cao, J., Ilmanen, A., & Villalon, D. (2025). Rebuffed: An Empirical Review of Buffer Funds. The Journal of Portfolio Management, 51(10).

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