Insuring the Investment Portfolio

We insure our life, health, our houses, our cars, teeth,

eyes, our jewelry, our art, our voices, our pets .......

why not our stocks and bonds?

If there were to be anything mystical in finance then it certainly would be in the realm of derivatives. For even many hardened financial professionals the very word conjures images that are horrific enough to be refuted at the first sign of suggestion.  Advisors balk and shun the very thought of discussing the possibility of introducing the concept to a client as a part of the portfolio. While most advisors have studied these instruments in some detail, their application in everyday portfolio construction and risk management remains a mystery; thought of, practically never used. Yet these instruments were created primarily for risk management.  Unfortunately for the investing population at large these instruments were discovered by aggressive speculators and gamblers. Unfortunate, because the spectacular abuses of these instruments were fodder for sensationalized media attention and the eventual misperception among investors that the use of these instruments should not be used in any way or to be avoided at any cost.  Financial advisors run a huge risk of losing their clientele were they to even suggest the inclusion of these instruments as part of a portfolio

Strange as it may sound, advisors think nothing of suggesting an indexed annuity and similar structured notes to suitable clients as instruments that allow clients some downside protection and the ability to participate on upside market movements. A closer look would quickly reveal that often, underlying such instruments are basic put or call options. Such a closer look would also reveal that homespun construction of these products is not only fairly straightforward but also can be done at a fraction of the cost charged by the institutions that sell these products. This article will briefly examine three separate applications that can be employed by advisors as a way to enter the realm of derivatives in the field of portfolio construction and risk management.

The 1987 market crash was often blamed on portfolio insurance. In that case, portfolio insurance was much more a computer driven technique of buying and selling securities as a dynamic method of portfolio rebalancing. Program trading, as it was called, used computer program driven trading strategies that automatically generated trade decisions based on levels of security prices and security holdings. Unfortunately, during the crash, these programs could not detect the free falling market and continued to enact sell orders every time the market hit some threshold level. The result was the spiraling effect of falling market levels generating further sales which fueled further price declines. Since the crash, portfolio insurance and program trading are not popular today anymore as they were in the mid-80s.

In this article the term portfolio insurance should be reckoned the very same way as we think of insurance - protection against or the mitigation of pure loss.  Analogically consider an insurance policy on a house or a car. The policy protects the holder from a decline in the asset's value (insurable interest)  over a certain period of time. Over this period, if there is a loss in value (from a fire or a collision, for example) then the insurer compensates the holder for the amount of the loss. Another way to think of this transaction is that the buyer of the insurance transfers the downside risk of loss in asset value to the insurer and for which the insurer charges a premium.  Further, the insured has the option of negotiating the amount of the premium by not transferring the entire risk of loss. If the insured decides to do so (for example, having a deductible component in the auto insurance policy or insuring the house for less than its face value) then the premium is also reduced. In the first two techniques described below we will examine how put and call options can serve to provide nearly exact features of an insurance policy but applied to a client's investment portfolio.

Strategy #1: Using Put Index Options The more straightforward of these two techniques is to use index puts in conjunction with a portfolio. We will explore a simple example to explain the technicalities. Assume that your client holds a portfolio worth $ 1 million invested in large cap stocks and tracks the S&P 500 index very closely. Also assume that the S&P 500 index is at 1000. To fully insure this portfolio from any loss, divide the portfolio value by the strike price (which is the value of the index today, 1000, times 250 (the S&P 500 index option multiplier). The answer of 4 tells you how many "at-the-money" index puts to buy. If the premium on the put is $50 (on a one year option), then the total cost of insurance is $60,000 (60*250*4), or 6% of the portfolio's total value. If the market trends downward during the year, the portfolio is nearly fully protected (it is fully protected if the correlation between the portfolio (of large cap stocks) and the S&P index is 1). For steep declines (declines of 10% or more) the cost can actually go down to some extent. However, if the market moves up, the investor is able to participate in the upward movement and the portfolio will increase by about the same amount as the market minus the 6% premium. For example if the market increased by 15%, the portfolio would increase by 9% whereas if the market declined by 15%, the portfolio would only suffer the 6% cost of the premium.  To get an idea on the utility of such an approach consider that between 1989 and 2006, the DJIA dropped by more than 12% over a 90 day period 30 times. Figure 1 shows the representation of the hedged portfolio in comparison to the unhedged portfolio for various index levels at maturity of the strategy.

Figure 1: Portfolio Hedge using an Index Put Option

If the investor felt that the premium was too high then they would also have the ability to lower the premium by not transferring the entire risk of loss. In this case the investor could use a lower strike price ("out of the money") of say, 950 (which would still require 4 contracts, rounded down), which would reduce the premium by a certain percentage, say for example to a cost of 4%. In this case, if the market moved down to 950 over the year (worst case), the loss would be 9%. Further declines would reduce the loss amount. However, if the market moved up, then the investor will fully participate on the upside minus the 4% cost of insurance. This example is similar to underinsuring a house. For example, if you insured a $500,000 house for $400,000 and a fire partially damaged the house where the damage was assessed at $100,000, then you lose both the 100,000 and the premium.

Strategy #2: Using Call Index Options There are some disadvantages in the above technique. Most investors do not hold portfolios that track the S&P index perfectly (correlation of 1). The difference in co-movements leads to an error in the hedging plan where the outcomes are different from that what is expected from a perfect hedge. This difference, arising due to the basis risk, as the tracking error affect is termed, may lead to outcomes that are not fully desirable. Another problem is that the above strategy can be quite expensive. The second approach mentioned next overcomes some of the problems in the put option hedge approach. In this case an investor would buy a call option on the S&P index (or a combination of call options in various indexes if the investor wanted to diversify the portfolio). In a manner similar to the previous example, the number of call options to buy would be determined in exactly the same manner as earlier. In this case, assume that the premium on a call option is also $ 60, just as in example only. In reality, the value of the put and call would be determined by put-call parity. The 4 call option contracts would cost a total of $60,000. The remaining $940,000 would now be invested in a money market account. Assume too that the one year money rate is 3%. At the end of the year the money market fund would have earned an amount of $28,200. If the index value at the end of the year was either unchanged or at any level below 1000, then the portfolio value would be $968,200 (a loss of $31,800, or 3.18%, the cost of the insurance). For example, if the market went down by 20% during the year, the portfolio would only be down by 3.18%.  If the index closed at a level higher than 1000, then the value of the portfolio would be the percentage increase in the index minus the 3.18%. The investor would earn a return of 16.82% for a market level increase of 20%. As can be seen from this example, this technique is not dependent on errors due to basis risk and is cheaper to implement. Figure 2 shows the representation of the hedged portfolio in comparison to the unhedged portfolio for various index levels at maturity of the strategy.

 

Figure 2: Portfolio Hedge using an Index Call Option

It is interesting to note that the returns from the above strategy can be replicated with a portfolio comprised of large cap stocks and bonds. A simple comparison of this replicated strategy will quickly show that the Sharpe ratio of the call strategy portfolio will overwhelmingly dominate the stock/bond portfolio. In fact, the above strategy is not only clearly superior in any risk/return measure to any asset allocation strategy using mainstream asset classes but also infinitely easier to execute as it totally eliminates the efforts and costs of security selection, allocation and monitoring activities.

Strategy #3: The Collar " a.k.a. the "Fence" Strategy  The final technique represents a departure in strategy and motivation from the above two techniques where loss prevention or mitigation along with upside participation was the sole purpose. These two techniques are better used when the advisor has reason to believe that a market correction is impending but does not wish to lose out on the upside potential in case the expectation proves to be unfounded. The application of this third technique is more suitable in situations where there exists considerable uncertainty (both up and downside movements) about impending changes in the market and while the investor does not wish to jump into the fray and begin investing due to risk of loss but also does not wish to be left behind if the market starts moving upward. In such a case an investor may apply this technique whereby if the market moves down, the investor's losses are minimal but is return is willing to forego the total return from large upward movements of the market by capping the returns received at some specific level. As before, this strategy, often termed as a "Collar" or "Fence", is much easier explained with a simple example.

To begin with, continue assuming that the investor holds a portfolio of large diversified stocks as in the first technique which is also equal to $ 1 million. The collar strategy requires this investor to buy an equivalent number of "at-the-money" put (i.e. 4 contracts in our example) and sell an equal number of "out-of-the-money" calls. Assume that the premium on the call options with a strike price of 1050 (index level) is $ 50. In this case, the net cost of the strategy would be $10 ($60 for the long put - $50 for the short call) or a total cost of $10,000 (or 1%). If the ensuing period, the market at any level equal to or less than 1000, then the portfolio value would rest at $990,000 or a maximum loss of 1%. If the index moved to a level of 1050 or above, then the portfolio would also rest at a value of $1,040,000, or a maximum gain of 4%. The strategy would have a "floor" (max loss) of 1% and a "cap" (max gain) of 4%. This cap and floor represents the two ends of the "collar". For index levels between 1000 and 1050, every unit increase in the index level would represent an increase in portfolio value of $ 1000 which would then be netted from the $10,000 cost of the strategy to arrive at the final portfolio value. For example, if the index settled at 1010, then the portfolio value would equal $ 1,000,000 (the gain of $10,000 on the portfolio would be exactly offset by the cost of the strategy). As can be observed from this discussion, this technique is well suited for investors who are "fence-sitters" and who cannot decide when to jump in. Figure 3 shows the representation of the "collared" portfolio in comparison to the unhedged portfolio for various index levels at maturity of the strategy.

 

Figure 3: Collared Portfolio using a long put and a short call

All the above strategies illustrate the straightforward nature on structuring portfolios to manage downside risk with minimal loss in upside participation. A way for investment advisors to become comfortable in these applications is to explore the strategies by using "funny money" portfolios to simulate actual outcomes under various market outcomes. Most professional derivatives trading websites offer trading platforms where advisors can learn the ropes of these strategies by replicating various portfolios using hypothetical dollar amounts. It is quite assured that the advisors who are adventurous enough to tread this path will find the rewards overwhelming. The few who provided such strategic services before the recent financial crisis have already reaped their rich harvests.

Dr. Basu is a professor of finance at the California Lutheran University and also the President of Financial Health Technology, Inc. a personal financial software company. Review at www.financialhealthtechnology.com.