What Is Portfolio Insurance?
Portfolio insurance is the strategy of hedging a portfolio of stocks againstmarket risk by short-selling stock index futures. This technique, developed by Mark Rubinstein and Hayne Leland in 1976, aims to limit the losses a portfolio might experience as stocks decline in price without that portfolio's manager having to sell off those stocks. Alternatively, portfolio insurance can also refer to brokerage insurance, such as that available fromthe Securities Investor Protection Corporation (SIPC).
Key Takeaways
- Portfolio insurance is a hedging strategy used to limit portfolio losses when stocks decline in value without having to sell off stock.
- In these cases, risk is often limited by the short-selling of stock index futures.
- Portfolio insurance can also refer to brokerage insurance.
Understanding Portfolio Insurance
Portfolio insurance is ahedging techniquefrequently used by institutional investors whenthe market direction is uncertain or volatile. Short selling index futures can offset any downturns, but it also hinders any gains. This hedging technique is a favorite ofinstitutional investorswhen market conditions are uncertain or abnormally volatile.
This investment strategy usesfinancial instruments, such asequities,debts, and derivatives, combined in such a way that protects againstdownside risk. It is a dynamic hedging strategy that emphasizes buying and selling securities periodically to maintain alimit of the portfolio value. The workings of this portfolio insurance strategy are driven bybuyingindex put options. Itcan also be done by using listed index options. HayneLeland and Mark Rubinsteininvented thetechniquein 1976 andit is often associated with theOct. 19, 1987, stock market crash.
Portfolio insurance is also an insurance product available from theSIPCthat provides brokerage customers up to $500,000 coverage for cash and securities held by a firm. The SIPC was created as a non-profit membership corporationunder theSecurities Investor Protection Act. TheSIPC oversees the liquidation of member broker-dealers that close when market conditions render abroker-dealerbankrupt or put them in seriousfinancial trouble, and customer assets are missing.
In aliquidation under the Securities Investor Protection Act, SIPC and acourt-appointed trustee work to return customers’ securities and cash as quickly as possible. Within limits, SIPC expedites the return of missing customer property by protecting each customer up to $500,000 for securities and cash (including a $250,000 limit for cash only).
Unlike the Federal Deposit Insurance Corporation (FDIC), theSIPC was not chartered by Congress to combat fraud. Although created under federal law, it is also not anagency or establishment of the United States government. It has no authority to investigate or regulate its member broker-dealers. The SIPC is not the securities world equivalent of the FDIC.
Benefits of Portfolio Insurance
Unexpected developments—wars, shortages, pandemics—can take even the most conscientious investors by surprise andplunge the entiremarket or particularsectors into free fall. Whether throughSIPC insurance or engaging in a market hedging strategy,most or all of the losses from a bad market swing can be avoided. If an investor is hedgingthe market, and itcontinues going strong withunderlying stocks continue gaining in value, aninvestor can just let theunneeded put options expire.
