Portfolio Insurance May Have Worsened Selloff, Traders Say
In December, 1986, New York Stock Exchange Chairman John J. Phelan warned a Washington audience that a new form of computerized stock and futures trading known as portfolio insurance could someday lead to “financial meltdown.”
The markets laughed him off. But with much of Wall Street’s panic selling in the last week being blamed on the activities of portfolio insurers, whose computer programs are designed to hasten selling when the markets turn down in an effort to protect clients from the impact of sharp declines, Phelan’s term may now have burned itself into the stock market’s permanent lexicon.
For there are strong indications that computerized portfolio insurance programs inspired the snowballing waves of selling during the market’s catastrophic collapse.
The impact of portfolio insurance programs on the market’s epic free fall Monday and last week cannot be precisely gauged. But estimates place the amount of assets “protected” by the programs, including the vast securities portfolios of such institutional investors as Aetna Life & Casualty Co., at as much as $61 billion.
Because of the mechanics of portfolio insurance, a significant portion of that pool of cash was poised before last week to begin marching, all at once, in a single direction: down. “If that money’s all moving at the same time, it has a considerable impact,” Robert Gordon, president of Twenty-First Securities, a New York investment management house, said Monday.
What’s more, the leading insurance technique involves selling not stocks, but related stock-index futures, and using the proceeds to offset stock losses. As the selling waves hit the futures markets, they drive futures prices down, which in turn drag stock prices down like water spiraling down a bathtub drain. Participants in stock and futures markets say that is exactly what set off the mind-numbing stock price collapses of Thursday afternoon, Friday and Monday.
Even people who sell portfolio insurance acknowledged that the technique is probably a leading villain of the market collapse--and what’s more, failed to protect clients from the losses they thought they would avoid. The reason is that stock-index futures have collapsed this week as much or more than stock prices--so the insurance clients realized only a fraction of the gains from selling the futures that they need to adequately protect themselves.
“Portfolio insurance had a lot to do with creating this market,” said Preston W. Estep, head of a leading portfolio insurance firm. “Everyone who deals in it will have to go back and do what they can to repair the damage to their reputations.”
Many users of portfolio insurance, say traders in the stock and futures markets, may have suffered worse losses in the last few trading sessions than they would have by just trading stocks. And the cost of the sophisticated hedges they installed while the market was still going up may have deprived them of a full measure of profits from the bull rally.
Portfolio insurance firms all use somewhat different computer models to dictate trading for clients; some were apparently more successful than others in protecting clients from losses this week and last week. But all showed they had devastating shortcomings, Estep said.
“Our customers are still ahead (of the rest of the market), so this is a day of jubilation for us,” he said. “But that’s got to be luck. This just happened to be our day in the sun. Everybody’s going to have to adapt.”
The NYSE’s Phelan scarcely shied away from remarking that his prediction may have come true. He told a press conference in New York after the market’s close Monday: “This is the nearest thing to a meltdown I’d ever want to see.”
For more than two years, futures and stock traders have been confronting fears and charges that the growing interrelationship between the two markets was undermining traditional safeguards against a serious crash--including limitations on using borrowed money to buy stock. Because futures can be bought with down payments worth a fraction of the value of the corresponding stocks, critics have charged, the entire stock investment world was becoming dangerously dependent on borrowed money.
Today, even veteran futures traders acknowledge that might be true. “We thought the market was big enough to take care of itself,” said Scott T. Ramsey, managing director at Index Futures Group in Chicago as futures prices collapsed in midday. “But maybe it’s not.”
Hedging Techniques
Portfolio insurance is one of several investment techniques using the stock-index futures markets as tools for hedging and moneymaking. In general terms, stock-index futures are contracts traded on commodity exchanges in Chicago, New York and Kansas City that are designed to replicate the price movement of a corresponding group of widely followed stocks.
The most heavily used stock index is the Standard & Poor’s 500 index of widely followed institutional stocks, although many traders also use the so-called major market index, which was designed to closely track the performance of the Dow Jones industrial average.
As the market has grown over the last two years, stock index futures have become the equivalent of a bet on the general direction of stock prices.
Program traders, who trade stocks and futures in tandem to achieve profits based on tiny price differences between the two, have often been blamed for exacerbating the sharp stock price moves of the last few years because their computer programs are designed to order the sale or purchase of millions of dollars of stocks in the blink of an eye.
Portfolio insurers add another bias to that system: one that encourages sharp downturns.
Take one of the most widely used systems of portfolio insurance, developed by two business professors at the University of California, Berkeley, named Hayne Leland and Mark Rubenstein and marketed by a Los Angeles firm, Leland O’Brien Rubenstein Associates. Leland and Rubenstein termed their system “dynamic hedging.”
Leland O’Brien clients hire the firm or license its computer program to protect themselves from, say, a 5% decline in their stocks’ value over a given period of time. When a market decline approaches that point, the computer issues an order to sell a huge quantity of stock-index futures as quickly as possible and at virtually any price. Theoretically, the client takes the money raised from selling the futures and invests it in Treasury securities--offsetting his losses in stocks.
“You pick a floor (the largest loss you are willing to suffer), and when you get near it you start selling like mad,” says one futures trader familiar with the system. “That means you’re placing large orders, and they’re bunched together.”
Futures traders and portfolio insurers said that, because of peculiarities in the Leland O’Brien system, its clients may have suffered particularly heavily.
Principals of the firm remained unavailable for comment throughout the day. Late Monday, however, a spokesman for Leland O’Brien President Larry Edwards issued a statement indicating that Monday’s wild market had prevented the firm from executing the full complement of necessary futures sales for clients.
“Although accounts being protected . . . have achieved substantial protection through the realization of hedge gains, these gains to date have been less than the planned amount,” it said.
More important than clients’ individual losses, however, is the way portfolio insurance tends to magnify market slumps. Because the clients’ concerted selling forces futures prices down, that attracts investors who strive to make money from the difference in price between the futures and their related stocks. In roughly simultaneous transactions, they buy the futures and sell the corresponding stocks. In turn, that forces stock prices further down, which kicks in more insurance-related sales in the futures markets, and so on.
