THE SAME OLD SHORTCOMINGS
by Michael J. Panzner
July 10, 2007

On the face of it, it seemed like a great idea: an insurance policy for investment portfolios. No wonder it was popular with the Wall Street crowd. Unfortunately, it was not until the strategy was put to the test in the fall of 1987 that its many shortcomings came to light. By then, of course, it was too late.

“Portfolio insurance” was first developed more than two decades ago in an attempt to limit the damage caused by significant share-price declines. Previously, fund managers found it hard to adjust quickly to sudden market turbulence, mainly because of practical issues associated with rebalancing large portfolios at a time when technological solutions were limited and communications networks sluggish.

Dreamed up by academics Hayne Leland and Mark Rubinstein -- who were later joined by marketing whiz John O’Brien -- portfolio insurance involved adjusting hedges or cash holdings in discrete steps that were tied to changes in market values, a process known as “dynamic hedging.” The lower prices went, the larger the offset and the smaller the exposure to additional downside risk.

Generally speaking, the Leland O’Brian Rubinstein Associates, Inc. (LOR) approach necessitated selling more and more index futures as prices fell. The goal was to immunize portfolios against the full bore of bearish red ink. In some respects, it was a glossed-up version of the mechanical stop-loss tactics long employed by traders and chartists.

For a while, the strategy worked reasonably well, and it gained widespread acceptance. That was because once threshold levels were hit, portfolio managers would find themselves effectively in cash without the logistical hassles or high transaction costs of the past. By 1987, it was estimated that portfolio insurance covered some $60 billion of equity-related assets.

In the wake of the October crash, however, investors learned a few hard lessons. They suddenly realized, for example, that the strategy assumed trading conditions would remain as liquid as they had been and that there would always be willing buyers at a price. LOR and its clients also reckoned that various structural and statistical relationships would remain intact, even when markets were under stress, which proved to be wide of the mark.

Beyond that was the belated recognition that the LOR approach wasn’t really insurance in a traditional sense. For one thing, there was confusion about the insured perils and the odds of their occurrence. While portfolio insurance did offer protection against certain threats, they were not necessarily the one that investors were really worried about.

The popularity of the dynamic hedging approach also ensured that it would fall short when needed most. It’s one thing, for example, to underwrite flood insurance for a single residence in a low-lying coastal area when others in the risk pool are located much further inland. It’s another to insure a great many homes in a vulnerable locale against the same threat.

Perhaps the most insidious aspect associated with the widespread use of portfolio insurance stemmed from moral hazard. Investors felt fully protected, and saw little need to watch out or steel themselves for a negative turn in the cycle. They reduced cash holdings to a minimum, and many sought to capitalize on the most marginal of opportunities.

Thus, instead of protecting investors, portfolio insurance ended up meting out a great deal of punishment. While some of those who were covered derived a measure of relative benefit from the incremental short-sales that took place in the days leading up to the crash, most experts believe the onslaught of sell orders only worsened matters, hurting everyone in the process.

Needless to say, enthusiasm for portfolio insurance waned after that, though the search for allegedly foolproof methods of controlling risk remained. Nowadays, aided by advances in knowledge, computing power and technology, increased electronic connectivity, industry consolidation, and a gusher of cheap money, various tactics, approaches, and regulatory mechanisms have somehow morphed into a framework that many once again view as protection from bear markets.

Taken together, they constitute a larger and more pervasive, and ultimately much riskier version of the protective backstop that many investors thought they had in place in the mid-1980s. In essence, what exists today is what might be described as the virtual equivalent of old-fashioned portfolio insurance.

And along with it, the very same threat of a devastating crash that investors faced before.

To be sure, most people probably wouldn’t characterize the ethereal and loosely constructed shield that the financial community seems to be counting on nowadays as “portfolio insurance.” Yet, one could argue that the widespread and hubristic enthusiasm for large-scale risk-taking is prima facie evidence of its existence.

How else can one explain the mind-boggling degree of speculation -- leveraged or otherwise -- now taking place in global financial markets? Or the notion that concentrated bets and out-sized holdings of illiquid and other risky assets makes more sense than traditional investment management approaches?

Logic suggests that only those who are very confident about their potential downside risk would dare to be fully invested at a time when credit spreads are at historic lows, various indicators point to an impending downturn, bond yields are rising sharply, and structural imbalances are at levels that have triggered financial crises in the past.

In fact, if you look hard enough, there is a great deal of evidence pointing to the existence of a portfolio insurance-style protective latticework, with a reach that stretches the length and breadth of the financial marketplace.

Some attributes are formulaic, like the dynamic hedging strategy used in LOR’s approach. Many Wall Street firms, for example, rely on risk management models that churn out real-time hedging parameters, though most are driven by changes in volatility rather than price. The phenomenal growth of the hedge fund sector, where performance is frequently measured in absolute terms over short spans, has spurred the widespread adoption of mechanical trading tactics such as stop-losses. Prime brokers use percentage-based margin requirements to keep risk exposure in check.

The illusion of permanent liquidity, which buttressed the 1980s classic, also plays a starring role in promulgating the growing acceptance of today’s virtual equivalent. With point-and-click trading technology, instant communications, arbitrage powerhouses operating across markets and borders, and portfolio-based risk management, more investors than ever are convinced that they have an “out” if they need it.

And as was the case in the years leading up to the 1987 crash, when positive feedback from early adopters of the strategy powered a wave of demand that sowed the seeds of its eventual undoing, the financial world has been similarly smitten to excess by the apparent “successes” associated with the modern version. The resolution of one crisis after another, including the LTCM and Amaranth meltdowns, has spurred complacency very reminiscent of two decades ago.

While these days no one is really interested in the protective backstop that LOR created, much of the investment world has nonetheless been signing on to its new age equivalent. Eventually, though, when prices start heading south -- as they are wont to do every now and then -- those naïve enough to believe that they have insurance against bear markets will realize once again -- belatedly, of course -- its many shortcomings.

Michael Panzner is author of The New Laws of the Stock Market Jungle: An Insider’s Guide to Successful Investing in a Changing World and a 25-year veteran of the stock, bond and currency markets. His book, Financial Armageddon: Protecting Your Future from Four Impending Catastrophes, was featured on Financial Sense Newshour.