Portfolio insurance reduces downside

Insurance is used to protect against unexpected losses. Traditionally, insurance is to protect the financial well-being of an individual or a company in the case of unexpected loss of life or property.

Not insurable
Unfortunately, there is no insurer for financial losses. For an asset to be insured, it must be insurable, ie the losses must be random in nature. Financial assets fail to meet this criterion, as stock prices fall in tandem with economic downturns.

Due to changes in economic direction — or more simply, the movements of funds from one asset class to another — stock prices do not move randomly.

Since stock prices move in a herd, it creates a cyclical pattern. This behaviour does not allow insurance companies to provide protection against financial losses. Otherwise, it will be much easier for investors to protect their equity investment from losses during financial crisis by paying some insurance premium.

Investors who want to protect their investment will have to look for some other alternatives. So long as there is an instrument that can mitigate investment risk, it is worthwhile exploring.

Understand the risk
Insurance is a form of risk management that can be used to hedge against the risk of a contingent loss. To reduce or mitigate investment risk, it is necessary to know what risk we are trying to avoid and what we want to be shielded from. It may also be crucial to protect the capital or profit during a certain period.

Every investor knows that there is a risk when investing. Although many investments provide higher returns in the long run, unexpected events may cause losses to investors from time to time. The sudden collapse of stock prices due to a fall in market sentiment, war, changes in government policies or other financial mishaps is a major reason why many people shy away from investing in the stock market.

Portfolio insurance




Unlike traditional classes of insurance, portfolio insurance was only developed about two decades ago. It was designed to limit the losses in a portfolio of investment from significant and sudden share price declines. The need for portfolio insurance to protect against downside risk is felt especially among the larger funds where, for practical reasons, disposals and rebalancing of portfolios are more difficult.

Unfortunately, unlike traditional classes of insurance where a specific risk can be insured, portfolio insurance is not perfect and has many limitations.

Use options and futures as a hedge
Essentially, portfolio insurance is a hedging strategy against market risk, which it does by selling index futures or buying stock index put option. The former is our stock index futures (FKLI), but the latter is not available in Malaysia.

For a large institution where stocks invested in the portfolio are similar to the 30 stocks of FBM KLCI, selling FKLI can be a good proxy. In the absence of other index futures, the correlation between a portfolio and the KLCI is crucial in determining how good the hedge is. The delta between the two asset classes is the hedge ratio, which is used to compute the required number of contracts to sell to optimise the hedge.

Short-selling of index futures to protect a portfolio from dropping below a certain level can only be effective if it is done before the market declines. However, shorting the index futures while market is falling can still be useful to protect against further downside of a portfolio value.

The gains from the short-selling index futures in a falling market will be able to offset the losses in the deteriorating portfolio value. In other words, by short-selling index futures, the value of portfolio can be protected. An illustration is shown in Table 1.

A portfolio of shares similar to the components of KLCI with a market value of RM250,000 can be hedged or protected by short-selling four index futures contracts of FKLI at the 1,200.0-point level, say. The value of the futures contract is RM240,000. If the market depreciates by 10%, the portfolio value will fall by RM25,000, but the loss will be offset by a gain of RM24,000 from the shorting of FKLI (assuming the FKLI also falls by 10%). The end result from this portfolio insurance is that the final portfolio value fell only to RM249,000 (ignoring the small hedging costs).


On the other hand, if the market appreciates by 10%, the portfolio will not benefit from the market run-up, as losses from the short contracts will offset price appreciation of the equity portfolio.

Insured for the short period
The form of hedging above will help to lock up the portfolio value before the futures contracts are expired. Although such an insurance may not be a perfect hedge in the sense that a portfolio may have a different composition from that of KLCI, it does help to mitigate the losses when market declines. The number of contracts is determined by the hedge ratio, which is linked to the co-movement between the portfolio and the benchmark KLCI.

Normally, such protection can be used for the short-term period only, as index futures can be sold readily for the current or next month contract which is more actively traded. Nevertheless, such short-term insurance is still useful when an investor is away or busy for several weeks but does not want to sell the shares which are kept for longer term purposes.

If the shares are disposed off and bought back later, it will involve unnecessary transaction costs, not to mention the possibility of loss of dividend during the period. Selling the FKLI short as insurance can also be employed during short periods of uncertainty, eg tension in the Middle East or prior to a general election in a politically less stable country. Fund managers may also use this insurance towards end of the year to protect the portfolio profits.

Protection via put warrant
A put option is also another method to develop portfolio insurance. Unfortunately, there is no options market in Malaysia. A put option is a financial instrument similar to shorting an asset, allowing its buyer to sell a stock or index at a pre-determined price.

Recently, OSK Investment Bank launched three local stock put warrants — Axiata-HA, Genting Malaysia-HA and IOI-HA — which can be purchased to protect the downside of the underlying stocks over a longer period. For put warrants on an index, the same investment bank also issued a 2-year FBMKLCI-HA for investors who want to hedge against the fall in KLCI.

For those invested in Hong Kong market, HSI-H1 — which will mature in August 2011 — may be considered as a hedge against a drop in the Hang Seng Index. A word of caution, however; the local put warrant may be less liquid due to limited participants. Another point of concern is the large premium of the warrants.

Protection via short ETF
Another form of protection is to buy a Short Exchange-Traded Fund (ETF), whose price moves in the opposite direction of a normal ETF. Choosing a relevant Short ETF is important to provide a better hedge. Some important considerations are the size of the Short ETF as well as whether it has sufficient liquidity to exit. Other factors to consider are the reputation of the sponsor, management fees, leverage and components in the ETF.

Some of the relevant Short ETFs are UltraShort Dow30 (to provide a hedge on global market) and UltraShort FTSE/Xinhua China25 Proshares (to provide a hedge against China stocks). Both of them are listed on the New York Stock Exchange.

Negative correlation — CTA
In the absence of a suitable short ETF, the next alternative protection is to have a perfect negatively correlated asset to go along with our core investment. There are not many asset classes which are negatively correlated with the equity market. When the economy falls, the values of many asset classes also fall in line. The only difference is the degree of price erosion.

One of the unique classes of investment which is negatively correlated with the equity market is trend following managed futures, or a Commodity Trading Advisor (CTA). These CTAs seek to profit from trends. They play long futures in a bullish market, and short futures in a bearish market.

In a clear up-trend market, they will generate profits like stocks and shares. They will perform particularly well during a bear market, when fear overcomes the emotion of investors, be it retailers or institutional investors. It is the ability of trend-following CTAs to profit from both bull and bear markets that makes CTAs an excellent asset class to act like portfolio insurance for traditional equity investment. The correlation between several asset classes is shown in Table 2.

Negative correlation — bond
Other than CTAs, long term bonds are also another asset class which normally behave differently from equity investments. The stock market normally performs well during periods of economic expansion, which coincide with rising interest rates. As a result, long term bonds may not perform during this period.

On the other hand, when the economy slows down and causes the stock market to fall, central banks normally reduce interest rates to revive the economy.

A cut in interest rates will lead to higher bond prices. As such, when the stock market is not performing during the period of a weak economy, a reduction in interest rate will boost the performance of bond investments.

As such, equities and bonds are an excellent combination in a long-term portfolio. This twin investment is commonly found in insurance companies and some bigger institutions.

Absolute return HFs
Another asset class that has a low correlation with the equity market is an alternative investment such as a hedge fund (HF). The main objective of most HFs is to provide absolute returns, regardless of market conditions. Examples of absolute return HF strategies are convertible arbitrage, long/short and relative value. In recent years, more and more HFs are targeting institutional funds. The appeal of HFs for institutions is their ability to generate consistent moderate returns, unlike the high volatility of stocks.

Unfortunately, the strategies adopted by most HFs hit a snag last year during the Lehman Brothers fiasco, and they too suffered huge losses. To be fair, most HFs only lost about 20%, half the losses of traditional long-only equity funds which tend to suffer 40% losses or more. Even though HFs may not function well during crisis period where poor liquidity truncated their performance, HFs are still relevant as their strategies will still work when market is back to normal.

Lowly correlated assets
Other than CTAs, bonds and alternative investments, there are not many asset classes which show a negative correlation with equity investment over a long period.

Having said that, there are many asset classes which have low correlations with share investments. Property investment is an excellent example in Malaysia. In the 1997/98 Asian financial crisis and the recent 2008 global financial crisis, Malaysian property prices stayed fairly firm even though stock prices collapsed sharply.

Having a diversified portfolio with different asset classes which are not correlated or lowly correlated is a useful way to reduce portfolio risk.

VIX & gold
BCA Research, in its October report, recommended the Chicago Board Options Exchange Volatility Index (VIX) and gold as suitable equity portfolio insurance. This is based on recent behaviour of these two instruments.

The VIX is the volatility index for investors to trade on equity risk. The inverse correlation of the VIX to the S&P 500 makes it excellent insurance to hedge against the fall in US market, and it is getting even more popular among institutional investors to protect their equity portfolio. The correlation of VIX with S&P 500 was -0.73 since Oct 2007 and -0.91 since March 2009, according to the report.

In the case of gold, its correlation with S&P 500 was -0.2 since Oct 2007, but increased to 0.71 since Mar 2009. Perhaps, gold is a better hedge against the fall of the US dollar than the fall of equity.

Have insurance in mind
Most investors invest to make money, but few think of insurance for their investment. For the long term strategy, diversifying into lowly correlated investment such as PROPERTIES [] and bonds is necessary. Buying into negatively correlated investments such as managed futures is an excellent choice to protect against another crisis which could be due to reversal of US dollar carry trade, collapse of yet another asset bubble created by low interest rates, etc.

For shorter-term protection, short selling an appropriate number of index futures contracts will reduce portfolio volatility over several weeks.

Investors should always have portfolio insurance in mind when investing as there is no insurance agent coming around to provide reminder on the importance of portfolio insurance.