Investors dream of an investment that provides all the return of the stock market without the risk of loss to principal of an investment in the market. That investment remains only a dream but there are exchange-traded funds (ETFs) that try to approximate such an investment. They are known as “Buffered" or "Defined Outcome ETFs.”

These may be suitable for investors who are willing to trade off some of the market's upside for some protection from the market’s downside. That makes them complex investments, so let’s try to better understand them. An effective way is to look at an example.

There are five key parameters in these ETFs:

• The reference security. This is the security that the ETF’s gains and losses will be measured by, for example, the S&P 500 index.

• The time period. This is when the outcome of the investment is determined and is typically 1-year.

• The reference price. This is typically the price of the reference security at the start of the time period.

• The cap. This is the amount of the gain in the reference security that the investor participates in, any gain above that is forfeited.

• The buffer level. This is the amount of downside in the reference security that the investor is protected against; any loss beyond that is the investors.

Let’s theoretically construct such an ETF to better understand how it might behave.

The reference security will be the S&P 500 index. (Note: the index does not include dividends; this is a significant disadvantage for the investor as they are typically in the 2% range.) The time period will be 1-year. The cap will be 10%. The buffer level will be 15%. The reference price is the price of the S&P 500 on Day 1 of the ETF’s issuance.

Suppose at the end of 1-year the index is up 8% and has paid dividends of 2%; the investor would get only a return of 8%.

If the index is up 12% and it paid dividends of 2%, the investor would get a return of only 10%, not 14%.

Suppose at the end of 1 year the index was down 10%; the investor wouldn’t lose anything because of the 15% buffer. If the index was down 20%, the investor would be protected against the first 15% of loss and would lose only 5%.

Hopefully, this example makes clear the tradeoffs in this investment vehicle. Keep in mind this is only an example; real ETFs are available with other buffer levels and caps. However, the two are not independent. The larger the buffer level is, the lower will be the cap; that is, the amount of upside the investor will participate in.

I would recommend these ETFs only for very conservative investors. This is because the stock market is upwardly biased. The market loses more than 15% in only about 12% of rolling 1-year periods and gains more than 10% in about 48% of those. Thus, an investor in these ETFs is likely to underperform the index plus its dividends in the longer term.

All data and forecasts are for illustrative purposes only and not an inducement to buy or sell any security. Past performance is not indicative of future results. If you have a financial issue that you would like to see discussed in this column or have other comments or questions, Robert Stepleman can be reached c/o Dow Wealth Management, 8205 Nature’s Way, Lakewood Ranch, FL 34202 or at rsstepl@tampabay.rr.com. He offers advisory services through Bolton Global Asset Management, an SEC-registered investment adviser and is associated Dow Wealth Management, LLC.

This article originally appeared on Sarasota Herald-Tribune: ROBERT STEPLEMAN: How do 'Buffered' or 'Defined Outcome ETFs' work?