Tuesday, February 16, 2016
Portfolio insurance - Back again?
I have seen some discussion in the financial press and from clients about portfolio insurance in the last month. This does not make a trend, but it does seem like a flash from the past. I lived the craze of portfolio insurance during 1987 and the end results during that crash were not pretty. Nevertheless, there may be a place for revisiting this strategy if it is placed in the proper context of asset allocation. The rationale for portfolio insurance strategies is simple - there is a need for positive convexity to help when markets can move to extremes.
You can go back almost 30 years to get a good feel of the foundation for this key asset allocation issue. See Perold and Sharpe - "Dynamic Strategies for Asset Allocation". Think of portfolio insurance from a high level - an investor is trying to replicate an option through holding exposure in a risky asset and bonds. Hence, when the market goes up, you want to put on more risk exposure and when the market goes down you want to limit or cut exposure and switch to bonds. If you increase exposure in an up market and decrease it in a down market, you will get the non-linear pay-off of an option.
In a simple form, convexity can be achieved through not regularly rebalancing a portfolio. When you rebalance you will take exposure from those asset classes which are doing well and place it in the asset classes that have under-performed. This creates negative convexity and has value if the markets do not move to extremes but if there are extended moves, there is value doing the opposite. Letting exposure ride when they are trending up is a momentum strategy. Momentum will give you positive convexity in up markets. If you cut exposure in down trending markets, you will also get convexity. The important part of portfolio insurance is reducing risk exposure in down markets. If the market moves to extreme you don't want to follow a strategy of rebalancing toward that asset class.
It seems that many investors have a problem with this allocation process, but you can get some of the same result with the choice of hedge funds added to a portfolio. Managed futures through trend-followers can be a key source of positive convexity across a broad set of assets classes. In fact, investors are paying for the diversification and search for trends on which to run positively convex exposures. A trend position in a market with stop-loss risk management is a simple form of portfolio insurance.
Implicitly, increasing managed futures and global macro exposure is a diversified portfolio of portfolio insurance strategies. You may be holding this old strategy without even thinking about it.