The investment avenues are rapidly increasing with the growth in the capital markets. This leaves the investor with a dilemma to select the right combination of assets that can reap him highest profits at lower risk. There comes the skill set of investment professionals, who combine agility with business acumen to fulfill the goals/benchmarks set by the investor. Portfolio insurance also falls under the gamut of services offered by a PMS entity which include, hedging a portfolio against vagaries of the markets.
“Don't gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don't go up, don't buy it.” Will Rogers
Investors are aware that their asset allocation decision i.e. the proportion of funds invested in different asset classes, is the most important one. According to academic studies more than 90% of the variance in a portfolio’s performance over time is due to asset allocation (Ibbotson et al., 2000).
Quantitative asset allocation has been approached as a two-dimensional optimization routine incorporating the variables, namely, mean and variance of returns. A bell shaped normal distribution curve is shown below to depict these returns (fig: 1). A risk-averse investor would shy away from risky assets to cash, ending up with lower variance and a lower expected return. While a speculative investor will go in the opposite direction, i.e. higher expected return at higher variance. But some managers might prefer to control some aspect of their portfolio returns and this leads to a non-symmetric distribution curve (fig: 2). The objective of a portfolio in this case is not just a mean-variance tradeoff; it involves certain other needs/issues.
“Options” are the building blocks for constructing payoffs to meet these complex objectives. Options can be used to create portfolio insurance. As options markets have matured, the emphasis has shifted towards using options strategically in the portfolio management. The following situations can give an insight about the same:
The investor can write a covered call when he believes that a stock offers scope for a small/negligible price appreciation.
The investor can buy a protective put when he holds a particular stock and fears a downside in the stock price.
Whereas the investor can buy both call and put when he is sure that there will be movement in the market, but is not sure on which side.
An entire matrix of option strategies ranging from bull spread, bear spread, strangle, strip, strap etc. are applied for varying conditions of market sentiment (bullish, bearish and neutral). The kinds of strategies applied depend on the ability to take risk. A risk averse investor after making profits in the market could add speculative element to his/her portfolio or could be cautious by taking portfolio insurance. The portfolio insurance strategies would be influence by the portfolio beta, which is obtained through empirical studies. Advanced academicians have devised ways to model time-varying beta.
“Futures” on the other hand, are linear products giving rise to unlimited profits and unlimited losses, hence are meant for speculative investors who would like to take directional calls on the market/stock. However, futures are useful in hedging/portfolio insurance. Beta-based strategies need to be deployed to hedge portfolios/specific stocks against severe price fluctuations.
Since futures are exchange-traded contracts, customisation to a particular entity’s requirements is just no feasible. Hence, there are times when the contract specification is different than what the hedging entity requires. In such a situation “surrogate hedging” is the concept prevalent in the market place amongst practitioners, at times referred to as “minimum variance hedge”.
The future of portfolio management and portfolio insurance is going to be system driven, with the rules being translated into system commands, deploying artificially intelligent decision systems to attain the goals of the investor.
References
Bookstaber Richard, “The Use of Options in Performance Structuring”, Journal of Portfolio Management, Summer 1985.
Markowitz, H. M., Portfolio Selection, Journal of Finance, 1952.
Roger G. Ibbotson and Paul D. Kaplan, Does Asset Allocation Policy Explain 40%, 90%, or 100% of Performance?, The Financial Analysts Journal, January/February 2000.
