Reprinted with permission from —

The International Newspaper of Money Management September 29, 1997

Jacobs blames portfolio

By Barry B. Burr The manuscript draws on behavioral Portfolio insurance was a fad that finance to examine aspects of portfolio helped to fuel the rising market, he insurance demand and the ensuing added. Portfolio insurance promoted by crash. In a section dealing with pre-crash Leland O Brien Rubinstein Associates Portfolio insurance appealed to advertisements for portfolio insurance, Inc. and other vendors not only caused investors having myopic loss aversion, LOR and vendors of LOR-licensed port- the 1987 market crash, but also he said in an interview describing the folio insurance, including Aetna Life helped fuel the then-record climb in book s contents. Insurance Co., advertised the product as equities preceding the plunge, according His work examines why portfolio foolproof. to a forthcoming book. insurance - also called dynamic asset Aetna, for example, called its product It suggests that 10 years later, the mar- allocation - caused the breakdown in guaranteed equity management. ket faces another potential crisis because the market on Oct. 19, 1987. In a promotional quote illustrated by of the great unknown consequences of The strategy was inherently destabi- Mr. Jacobs in his manuscript, Aetna what the newly completed book calls lizing to the market system, Mr. Jacobs states: the sons of portfolio insurance, writes. The strategy called for investing GEM gives plan sponsors an alterna- including options-writing strategies. into equities as the rose tive approach to the problem of control- Bruce I. Jacobs, principal and co-chief and selling as the stock market fell. ling portfolio risk by allowing them to investment officer with Jacobs Levy It is a positive feedback system participate in equity returns while plac- Equity Management Inc., Roseland, N.J., because it serves to amplify price move- ing absolute limits on downside expo- wrote a more than 400-page manuscript ments, he said. It will cause more sure. with the working title of Capital Ideas volatility and a magnification of . . . The key word is absolute , said and Market Realities: The True Story of uptrends and downtrends. Tate, who was Ralph S. Tate, vice presi- the Crash of 1987 and the Lessons We dent and director of portfolio manage- Have (and Haven t) Learned. Value investing s antithesis ment for Aetna s common stock depart- Harry Markowitz, who won a Nobel Portfolio insurance follows an ment. If a sponsor chooses a 0 percent prize in economics for his work pioneer- approach that is the antithesis of value return, he s never going to have to go to ing modern portfolio theory, has written investing, Mr. Jacobs says. Even tradi- his pension committee and explain loss- a foreword to the book. Mr. Jacobs hopes tional modern portfolio theory tends to es. Even the most conservative balanced to contract with a publisher soon. be a negative feedback system, because it or bond manager can t offer that. * In the book, he argues when market- tends to call for a scaling back on equi- Aetna had an estimated $17 billion of ing portfolio insurance, LOR and other ties as prices rise. the outstanding portfolio insurance. vendors played on institutional Portfolio insurance, however, Sources in the book cite the total market investors basic feelings of fear and encouraged investors to commit more at between $60 billion to $100 billion at greed, and concern over job security. to equities than they would otherwise. the time of the crash.

Displayed with permission of Pensions & Investments. Copyright 1997 by Crain Communications Inc. disclosure rule - to minimize trades based on mechanistic triggers, Failing to protect volatility on (corporate) income not fundamentals, as did portfolio But when the crash occurred, Mr. statements and raise returns on actu- insurance in 1987. Jacobs said, Liquidity wasn t there. arial rates to lessen (pension) contri- Mr. Jacobs is concerned whether Portfolio insurance universally failed butions. market interventions put in place to protect its floors, or target levels Portfolio insurance had substan- since 1987 to try to prevent another of protection. Then portfolio insur- tial credibility because it came from crash will work. ers were unable to take advantage of the academic community and acade- For example, he expressed doubts the market recovery. They lost out mic journals, Mr. Jacobs said. Two on the effectiveness of circuit break- on rising market opportunity over LOR principals - Hayne Leland and ers, which halt trading temporarily the next two years. Mark Rubinstein were - and still when the market falls 350 points, LOR began marketing portfolio arec- scholars at the University of giving investors a sort of timeout to insurance in 1982 when the market California at Berkeley. deliberate about the cause of a was coming off of 10 poorly per- decline. forming years and investors were Academic bias claimed He noted that after the market fell leery of , Mr. Jacobs said. It Mr. Jacobs, however, assails the precipitously the Wednesday, turned out that year was the start of bias of academic journals where he Thursday and Friday before the the bull market. tried several times to have his criti- crash, investors had an entire week- In another advertisement, cited by cism of portfolio insurance pub- end to sort out the falling market, yet Mr. Jacobs, Aetna brags about 10 lished before the 1987 crash. returned Monday to participate in years of GEM s simulated returns, He said publication of his work the greatest one-day crash. ending in 1982. was rejected by reviewers tied to the Also, he noted there is a gravita- What else makes our GEM strat- portfolio insurance market. tional pull of investors wanting to egy so remarkable? the Aetna ad Looking at it 10 years later, we get out before trading halts when reads. The investment technology can see no discernible fundamentals they see a decline approaching the credentials of Leland O Brien at the time responsible for the circuit-breaker trigger. In addition, Rubinstein Associates are impecca- crash, Mr. Jacobs said. The econo- he said, savvy front-running ble. my continued to grow and the mar- investors will start selling ahead In the interview, Mr. Jacobs said, ket rebounded, unlike in all previous when they see portfolio insurance Portfolio insurance had great crashes that were associated with investors following their mechanis- appeal because it was very aggres- financial panics and economic tic dictates to sell in the face of a sively and egregiously marketed as depressions. declining market. being a universal panacea. It was Mr. Jacobs is leery of sons of port- The timeouts don t cause any marketed as a way to protect assets, folio insurance now in the market. harm, though, he added. The real but at the same time it claimed it These include privately negotiated problem is when information is not could enhance returns and unleash put options with investment banks, fully revealed, such as mechanistic the aggressive investor, who because he said. portfolio strategies. of a (portfolio insurance) safety net, The great unknown is the magni- He said the new proposed FASB could put even more money into tude of the put deals, because rule on disclosure would stocks. they are private deals not disclosed, help investors know more about the Among other reasons, portfolio he said. The risk is the issuers may extent of these strategies. insurance was sold as a benefit to not have adequate resources to cover pension funds especially with FAS potential losses. 87 - the Financial Accounting Such strategies can trigger infor- Standards Boards then new pension mation-less trading, he said, that is

Displayed with permission of Pensions & Investments. Copyright 1997 by Crain Communications Inc.