The outlook for 2016 is not bright, with asset managers and consultants predicting the beginning of the end for the bull market. As Russell Investments put it, 2016 is expected to be “another lackluster year with markets moving sideways.”
“Portfolio insurance raises its head in every bear market.”Add in elevated market volatility, and the conditions are ripe for a piquing interest in the drawndown-protection strategy of ‘portfolio insurance.’
“Portfolio insurance raises its head in every bear market,” Brad Smith, a partner at NEPC, tells CIO. “There is an ebb and flow to investors’ interest in the strategy. Today, a lot of clients are concerned about the market and we expect to get more questions about portfolio insurance from plan sponsors if the market continues to trend down.”
So what does it mean to ‘insure’ a portfolio?
“Portfolio insurance has many meanings, but at the highest level, it is a risk-mitigating strategy that protects primarily equity-centric portfolios in the event of a negative environment,” says Tom Lee, managing director of investment strategy and research at Parametric’s Minneapolis office (formerly the Clifton Group).
But before you run to your favorite
manager and sign up for coverage, Lee warns investors that the concept can be difficult to digest.
The Basics
Let’s begin with the definition. Portfolio insurance is a strategy that hedges an equities portfolio against the market risk by shorting index futures. Its iterations run from tail-risk management to more mechanical strategies, according to Lee.
A true portfolio insurance strategy aims to offer downside protection, Lee continued. Before purchasing a put option, investors must determine a time frame—usually 6-, 9-, or 12-month periods—and a strike relative to the current market level. For example, if an investor purchases a 12-month 15% out-of-the-money protective put for 3.5% of the notional value of their portfolio, the portfolio insurance would only pay off if the market is 18.5% lower before the option expires.
However, generally investors are unwilling or hesitant to write a check for something that has “the king value,” Lee said. For example, if an investor commits to a put option for one year, 10% below the market, and pay 1.5% for it, the insurance fails to pay off unless the market breaks even with the premium by the time the option expires—or in this scenario, down below 88.5%.
To offset this premium, investors
can also use a collar, according to Lee, an options strategy that is
implemented after a long position has made substantial gains. Also known as a
“hedge wrapper,” a collar means buying put options (a protective) while
selling call options (extra profit potential) at the same time.
Official Recommendation: Not Worth It
“Portfolio insurance is not a good ongoing hedging strategy,” says NEPC’s Smith. “It’s very expensive and rarely pays off economically. If investors are concerned about losing money on the market, they are better off de-risking.”
By the time an investor implements portfolio insurance, he continues, the markets are already “very frothy on the downside,” with plenty of volatility. This can make options prices extra expensive, and difficult for the market to pierce the price on the downside long enough to add value.
“Portfolio insurance is not a good ongoing hedging strategy. If investors are concerned about losing money on the market, they are better off de-risking.”“Markets tend to always bounce back before the option expires,” Smith said. “Volatility is a good thing in a market. Let your managers take advantage of it, as long as you have a long investment horizon.”
Parametric’s Lee added that portfolio insurance is also a bear to implement because it requires the asset owner, manager, and often the board to understand, define, and manage hedges.
“There are ongoing decisions to make when it comes to portfolio insurance,” he continues. “It’s very challenging to not only manage the hedge, but decide when to get in, get out, and strike the put. Oftentimes, managers can’t make these recommendations; the risks investors are trying to hedge are unique to the fund.”
Accelerated volatility since last August has sparked more conversations with clients about portfolio insurance, Lee says. But the strategy is not gaining much traction, due to some of these difficulties.
However, both Smith and Lee admit there is a handful of instances in which investors are allowed to think short-term and hedging makes sense. When a company sells a nuclear power plant, for example, current market conditions might not align with liquidating nuclear decommissioning trust assets.
“But generally these situations are not in place,” Lee says. “Most of the time, investors are nervous about the market, volatility, and poor performance, and want to somehow stop it.”
In other words: Keep calm and de-risk.
Related: The Psychology of a Sell-Off