Abstract
The invention of portfolio insurance as a strategy for limiting portfolio losses was introduced in the early 1980s and gained spectacular popularity throughout the decade, attracting between $60 billion to $90 billion from institutional money managers. The method provided downside protection against a long equity position by synthetically replicating a long put option using equity futures during an era when exchange-traded equity options were not sufficiently liquid. Unfortunately, the strategy came to a catastrophic end on the “Black Monday” of October 19, 1987, when the president of the New York Stock Exchange shut down the nascent technology used by index arbitrage program trading groups. This caused significant mispricings between futures and cash markets, making the required synthetic put option replication trading impossible. The portfolio insurance strategy was declared a complete failure and never has since regained widespread popularity. Three decades later, modern markets now fully embrace program trading, and the likelihood that program trading would be shut down for any reason ever again seems impossible. This paper examines how portfolio insurance would have performed during the 1991 to 2020 time period, during which 3 major stock market crashes occurred and program trading was never shut down. The paper concludes that portfolio insurance received unjust blame for the 1987 crash and its abandonment since then has been irrational and unfortunate for those seeking long equity exposure with a cost-efficient strategy for limiting portfolio losses.
Highlights
An article featured in Fortune magazine in June, 1982, stimulated readers with the opening sentence [1] “It sounds too good to be true: a method for making money in stocks while avoiding their downside risk.” What followed in the years to come was a massive inflow of investments from institutional investors across the United States of America, clearly demonstrating the nearly universal appetite for what the creators of the strategy promised in their so-called “protective portfolio management.” This underlying financial innovation, known as portfolio insurance, was introduced in the early 1980s and gained spectacular popularity throughout the decade, attracting between $60 billion to $90 billion from institutional money managers
In a futile effort to abate a double-digit percentage daily loss in the S&P 500 equity index, the president of the New York Stock Exchange suddenly and inexplicably shut down the nascent technology used by index arbitrage program trading groups [8]
This caused significant mispricings between futures and cash markets, making the required synthetic put option replication trading required by portfolio insurance nearly impossible
Summary
An article featured in Fortune magazine in June, 1982, stimulated readers with the opening sentence [1] “It sounds too good to be true: a method for making money in stocks while avoiding their downside risk.” What followed in the years to come was a massive inflow of investments from institutional investors across the United States of America, clearly demonstrating the nearly universal appetite for what the creators of the strategy promised in their so-called “protective portfolio management.” This underlying financial innovation, known as portfolio insurance, was introduced in the early 1980s and gained spectacular popularity throughout the decade, attracting between $60 billion to $90 billion from institutional money managers. In an astounding episode in the history of financial markets, demand for the strategy collapsed shortly after the so-called “Black Monday” of October 19, 1987 On this day, in a futile effort to abate a double-digit percentage daily loss in the S&P 500 equity index, the president of the New York Stock Exchange suddenly and inexplicably shut down the nascent technology used by index arbitrage program trading groups [8]. In a futile effort to abate a double-digit percentage daily loss in the S&P 500 equity index, the president of the New York Stock Exchange suddenly and inexplicably shut down the nascent technology used by index arbitrage program trading groups [8] This caused significant mispricings between futures and cash markets, making the required synthetic put option replication trading required by portfolio insurance nearly impossible. Modern markets fully embrace program trading, and the likelihood
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