Portfolio Insurance

The financial product known as portfolio insurance was born the night of September 11, 1976.  Hayne Leland had recently returned from France, and had been lamenting the weakness of the dollar. Portfolio insurance is a dynamic trading strategy designed to protect a portfolio from market declines while preserving the opportunity to participate in market advances.

An early criticism of portfolio insurance was that it reduced return as well as reducing risk.  But users are discovering that portfolio insurance can be used aggressively rather than simply to reduce risks.  Long-run returns can actually be raised, with downside risks controlled, when insurance programs are applied to more aggressive active assets.  Pension, endowment, and educational funds can actually enhance their expected returns by increasing their commitment to equities and other high-return sectors, while fulfilling their fiduciary responsibilities by insuring this more aggressive portfolio.  Compared with current static allocation techniques, annual expected returns can be raised by as much as 200 basis points per year.
 

Properties of Insured Portfolios:

The return pattern of the insured portfolio has several important properties:

(A) The probability of experiencing any losses is zero.

(B) The return on any profitable position will be a predictable percentage of the rate of return that would have been earned by investing all funds in the S&P 500.

(C) If the portfolio is restricted to investments in the S&P 500 and cash loans, if the expected rate of return on the S&P 500 exceeds the return on cash, and if the insurance is fairly priced, then among all investment strategies possessing properties (A) and (B), the insured portfolio strategy has the highest expected rate of return.


Dynamic Asset Allocation Strategy

In this strategy, the manager replicates an option through continuously revising the proportions of a portfolio consisting of the underlying risky asset (stock/bond) and the riskless asset (bond/T-bill) to insure portfolio’s value.

This strategy requires buying more stock when the market is going up and selling off some stock as the market is goes down.

The proportions allocated to the underlying risky asset and the riskless asset change every period, so this strategy requires a significant amount of trading.

The number of units of the underlying risky asset that must be held long at any given moment will be given by the call option’s ‘Delta’, the reciprocal of how many calls it takes to hedge a unit of the underlying portfolio. The call delta tells us the number of units of the underlying portfolio to hold.

The amount of riskless asset to hold is determined by subtracting the value of the units held in the underlying asset from the total value of the insured portfolio.