Portfolio insurance is a hedging strategy developed to limit the losses an investor might face from a declining index of stocks without having to sell the stocks themselves.[1] The technique was pioneered by Hayne Leland and Mark Rubinstein in 1976. Since its inception, the portfolio insurance strategy has been dubiously marketed as a product (similar to an insurance policy).[2] However, this is a misnomer as it is not a policy and there is no insurer of last resort.
This strategy involves selling futures of a stock index during periods of price declines. The proceeds from the sale of the futures help to offset paper losses of the owned portfolio.[3] This is similar to buying a put option in that it allows an investor to preserve upside gains but limits downside risk.[1] Portfolio insurance is most commonly used by institutional investors when the market direction is uncertain or volatile.
In practice, a portfolio insurance strategy uses computer-based models to analyze an optimal level of stock-to-cash ratios in various stock market conditions. Though the number of owned shares could stay the same, the total portfolio value changes with the market. As the market drops, a portfolio insurer would increase cash levels by selling index futures, maintaining the target ratio. Conversely, the same portfolio insurer might buy index futures when stock values rise. This combination of buying and selling of index futures is done in an effort to maintain the proper stock-to-cash ratio demanded by the portfolio insurance model or strategy.[4]
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