It's Prone to Failure

Reprinted with permission from

The International Newspaper of Money Management November 16, 1987 It’s prone to failure

By Bruce I. Jacobs

The impotence of "portfolio insur- Some plan sponsors were tempted to their plan's surplus in light of FASB 87, ance" in the face of the Oct. 19 market lock up bull market gains, while others which requires pension liabilities to be meltdown is prima facie evidence that sought to buy "protected" equities to fur- placed on the corporate balance sheet. insured strategies are prone to failure. ther increase returns. Yet this standard has no direct impact on Moreover, portfolio insurance destabi- Portfolio insurance was originally a firm's cash flows, and solely cosmetic lizes the markets and sows the seeds of promoted as "free lunch." effects on the balance sheet and income its own destruction. Simulations highlighted periods of statement. If there are indirect effects on When the relationship between the spot poor equity returns, in which the tech- a firm's outstanding contracts specified and futures markets became unglued dur- nique not only limited losses but also in terms of reported numbers, these con- ing the market crash, many insurers decid- outperformed an uninsured approach. It tracts could be negotiated. ed to stand on the sidelines. They chose to was sometimes said that portfolio insur- Sponsors who have decided to lock in be unhedged in the face of the market ance is available for a negative premi- bull market gains may lock out future descent, rather than to sell futures at what um. That is, an insured strategy could gains, because insurance strategies were perceived to be "fire sale" prices. provide protection and also generate effectively reduce equity exposure. Is Portfolio insurance failed precisely when it more wealth. this not market timing in disguise? was most needed. Because portfolio insurance is syn- Still others have insured stocks to Meanwhile, recent limits placed on thetically created, there is no explicit have the comfort to increase their equity daily price swings on index futures cripple payment for premium. Rather, the cost allocation. This sounds like reducing synthetic strategies. Suggestions of of synthetic protection is imbedded in your profit margins, but hoping to make longer insurance horizons, while they the strategy. This differs from publicly up the difference on volume. After all, may resolve the potential for failure and traded put options for which explicit insuring stocks reduces expected return. destabilization of the market, will provide payment is made. At best, portfolio Those facing shorter investment hori- lesser protection and create another insurance reduces risk at a fair - not a zons might find insured strategies opportunity for a crash. bargain - price. appealing, because a "safety net" may The development of this industry in a Because portfolio insurance is merely permit equity ownership. Also, insured few short years has been nothing less responsive to market moves, it has no equities might be sensible for pension than phenomenal; recent estimates range foresight. It can be shown the imbedded plans of bankrupt companies that may as high as $90 billion invested in insured cost of protection equals the entire value- not otherwise be able to afford the risk strategies. added provided by a seer with a crystal of loss. How did it expand so quickly? ball. Such a perfect market timer holds In any case, the old and reliable rem- It's rapid growth was due to the suc- cash equivalents when stocks decline, but edy of diversifying risk appears to be the cessful promotion of insured strategies otherwise holds stocks. most prudent choice. Even if portfolio as a panacea for a variety of ailments. An investor on the other side of the insurance implementations work, and Actuaries stood ready to raise the portfolio insurer's trades should expect expected returns can be increased by return assumption for "insured" equities to earn higher rewards than the insur- concentrating assets in insured equities, Equity dedications, in lieu of debt, were ance buyer, and even higher rewards all bets would then be staked on one promoted. than those provided by the constant mix asset type. Superficially, the Financial Accounting policy (again, with the same standard Moreover, synthetic insurance strate- Standards Board's Statement 87 seemed to be deviation). gies suffer from some rather glaring a reason to consider surplus "protection". Some sponsors have decided to insure implementation pitfalls. Spikes in stock

Displayed with permission of Pensions & Investments. Copyright 1987 by Crain Communications Inc. prices or gap changes in sensitive parame- spot markets, or using stock index future management of the underlying assets and ters, such as changes in interest rate or contracts, the latter approached has the insurance overlay is under one roof, stock market volatility, will cause synthet- gained in popularity and has served to hedging can be done in whichever market ically created strategies to fail. fuel the growth of the portfolio insur- is most advantageous. The strategy can "stop-out", requiring ance industry. Recent limits placed on the daily a full commitment to cash equivalents, The use of future contracts for hedg- price swings of index futures cripple to guarantee the promised level of pro- ing allegedly reduces what are otherwise synthetic strategies. Publicly traded put tection. In this case, the investor will be substantial transaction costs in the spot options might offer some relief from shut out of subsequent rallies and may market. However, because the prices of implementation pitfalls but such options bear significant opportunity costs. The futures tend to lead the underlying spot are not available for long enough hori- opportunity costs of the insured strategy, markets, the insurer often buys dear and zons, have a limited availability of strike as measured by the loss of upside partic- sells cheap. prices, and suffer from their time-hori- ipation are comparable in both magni- Program traders arbitrage discrepan- zon dependency. tude and frequency to the downside pro- cies between the spot and future markets, Furthermore, U.S. options, unlike tection provided. but spreads can get severely out of line. their European counterparts, can be Still worse, however, the synthetic This happened Oct. 19 and 20, when the exercised at any time before expira- strategy is not fail-safe, and may miss the future discount to spot widened to as tion. This day-to-day protection is mark by a wide margin. This occurred much as 20%. While "price discovery" in unnecessary for the portfolio insurer Oct. 19, as the Dow Jones industrial aver- response to news does take place first in and would represent an additional cost. age plummeted 508 points. That day's the more liquid futures market, portfolio Some might suggest longer insurance downward cascade provided insurers little insurance hedging aggravated the futures horizons, synthetically implemented, opportunity for a graceful exit. price. A further avalanche of sell orders may resolve the potential for failure and Some plan sponsors had half or less of by insurers was expected, and front-run- the destabilizing influence on the mar- the promised protection. Several sponsors ning (exploiting the insurers' known trad- ketplace, but this notion is without have since suspended their insurance pro- ing rules) made matters worse. merit. grams, others have canceled and even some The chaotic market conditions inhibit- First, the effective insurance protec- insurance providers are considering with- ed program trading, which later was sub- tion is merely reduced. Second, length- drawing from the business. ject to temporary controls. There was lit- ening horizons just increases the mar- Tragically, portfolio insurance exac- tle liquidity in the spot market: bid/ask ket's capacity to accommodate insured erbates market movements and courts spreads were exceptionally wide; bids assets, and if this capacity is strained disaster. It does so by adding buying were not firm; and trading was halted fre- once again, meltdown will be unavoid- pressure as prices rise, and by contribut- quently because of order imbalances. able. ing to selling pressures as prices fall. By Program trading was simply too risky in Portfolio insurance was a bad idea destabilizing the marketplace it can that environment and fell to less than half whose time had come. In the wake of the bring on its own demise. its normal level despite the unusually debacle, however, it appears to be a bad Portfolio insurers need trading partners large spreads. idea whose time has gone. The explosive who are willing to sell insurance and bear As the spot/futures relationship growth of the portfolio insurance industry downside risk. If insurers enter the market- became unglued, many insurers decided has exhibited the characteristics of a fad, place faster than their partners, the dance to stand on the sidelines. whose bubble has now burst. becomes one-sided and prices gyrate sub- Oct.20, salt was rubbed in the wounds, stantially. The cost of protection rises, the as insured assets were whipsawed. The Bruce Jacobs is principal, Jacobs, likelihood of being whipsawed increases market rebounded sharply, but upside par- Levy Equity Management Inc., Fairfield, and the chance of a steep market descent ticipation was limited by the hedges that N.J. increases. In this environment, synthetic were now belatedly in place. strategies are more likely to fail. Apparently, those insured strategies Whereas synthetic strategies can be having the option to sell stocks in lieu of implemented in either the underlying futures emerged less bloodied. When the