Leland O’Brien’s Image Marred in ‘Meltdown’ : Pioneer Portfolio Insurers on the Defensive as Role in Market Skid Is Questioned
In the ancient history before Oct. 19, 1987, John W. O’Brien’s biggest problem was persuading the investment world to pay attention to the esoteric concept of portfolio insurance pioneered by the Los Angeles firm he and two UC Berkeley finance professors founded in 1981.
All that changed when the stock market collapsed, thrusting the investment management firm of Leland O’Brien Rubinstein Associates--the biggest player in a field of finance it virtually invented--into the vortex of a swirling controversy over what led to the worst crash in American history.
“We didn’t really have a public image before,” O’Brien said in an interview in his office in the First Interstate Bank building downtown. “Our image begins as a tarnished one. We can go from there.”
Features of portfolio insurance--used by institutional investors to protect against a falling stock market by trading in U.S. Treasury notes and futures contracts--are being blamed for what New York Stock Exchange Chairman John J. Phelan called a “financial meltdown.”
The Securities and Exchange Commission and the Commodity Futures Trading Commission announced reviews to determine the causes of the market volatility, with a special eye on the impact of portfolio insurers and the automatic computerized program trading that is a central feature.
Its role as the nation’s premier portfolio insurance firm has put Leland O’Brien Rubinstein, known as LOR, at the heart of that controversy.
As if being blamed for helping grease the skids in the crash were not enough, the firm also faces a barrage from customers who contend that its system failed to protect them.
“We’ve had some dismayed customers,” O’Brien conceded. “Several have said they want to put our protection plan on suspension while we figure out what went wrong.”
Such long-term customers as Manville Corp. and the Auto Club of Southern California said they are re-evaluating the effectiveness of portfolio insurance. Others said they won’t use it again.
“The system didn’t provide us the protection we thought we were getting,” said Margot Kyd, treasurer of San Diego Gas & Electric. The utility lost 17% to 20% of the value of its $350-million pension portfolio despite the use of an LOR program designed to guard against a loss of more than 5%.
Other clients, such as the investment subsidiary of Wells Fargo & Co., which had $9 billion of managed money subject to LOR’s portfolio insurance strategy, simply refused to comment on how they fared.
Some, however, have come to the defense of LOR, praising the company’s system for allowing them to avoid the brunt of the collapse by selling stocks and switching to cash or by selling futures tied to a stock index.
“I was responding to the LOR insurance strategy when I went fully liquid and converted to money markets on Friday, Oct. 16, and I stayed whole,” said Jonathan C. Jankus, portfolio manager for a $65-million mutual fund sold by the securities firm of Kidder, Peabody & Co.
A similarly protected fund at Merrill Lynch also reported that the technique had helped stem losses and left its $230 million in equity intact.
But the complaints of dissatisfied customers, coupled with concern over the role of portfolio insurance in the collapse, are forcing O’Brien and co-founders Hayne E. Leland and Mark E. Rubinstein to grapple with what can be described most kindly as an enormous image problem.
Leland acknowledged that the firm’s performance was mixed. But he added: “To say that we caused the collapse, that is preposterous.”
Nonetheless, LOR is clearly skittish about its current notoriety. Last week, the partners refused to allow their photographs to be taken, with a spokeswoman explaining, “Our counsel felt it was dangerous to allow their pictures in the paper in such volatile times.”
‘Rocket Scientists’
It’s all a far cry from the day in October of 1979 when John O’Brien first heard the phrase “portfolio insurance.”
O’Brien was developing new financial products for the A. G. Becker brokerage firm. He was attending a symposium sponsored by the business school at the University of California, Berkeley, when he heard two young finance professors explain their concept for protecting investments in the stock market.
The two Berkeley professors, Leland and Rubinstein, clearly fell into the category of “rocket scientists,” a Wall Street term for the theoreticians who devise exotic investment devices. Leland has a doctorate in economics from Harvard, and Rubinstein has an MBA from Stanford and a doctorate from UCLA.
Their theory was a means of doing something quite startling--making money in stocks while minimizing the risk. They called it portfolio insurance.
For many years, investors had been able to protect themselves by purchasing “put options,” the right to sell a stock at a specified price on a certain date. Puts are bought from investors who place opposite bets that the market will go up. Although puts cost a fraction of the actual stock’s value, they are costly. And there is not always a market for puts in every stock.
What Leland and Rubinstein said they had created was a system of protecting an entire portfolio, regardless of the availability of put options, and at a cheaper price.
When the market dropped, they explained, their computer program would cut losses by issuing orders to sell stocks and shift the proceeds to Treasury bills, among the least risky investments around. When the market went back up, the computer would instruct the customer to move back to stocks.
The computer would tell the customer precisely how much money to have in stocks and T-bills in a given market to ensure that the total portfolio’s losses would be held within pre-set limits, usually 5% to 10%.
The system also had its costs. It involved an enormous number of trades. In a more volatile market, there would be more trades and still higher costs.
There was an indirect expense, too. Investing a portion of the assets in T-bills meant that the return would be less in a bull market than on a portfolio invested 100% in stocks. That essentially amounted to the “premium” paid for the insurance, the professors said.
O’Brien saw the untested academic theory as a method for revolutionizing the way huge institutional investors, particularly pension fund managers, hedged the risk on their billion-dollar stock portfolios.
“I took the idea to Becker, but they felt it was too complex for them,” O’Brien said. “So, about three months later, I contacted Leland and Rubinstein and suggested that we form a business.”
Revolutionary Theory
After a year of talks and planning, the first office of Leland O’Brien Rubinstein Associates was opened in Century City in February, 1981. O’Brien was the only full-time employee; his wife was the part-time secretary. Leland and Rubinstein were “working directors.”
A month later, LOR got its first money to manage--a $500,000 “test” portfolio from Becker. O’Brien kept trying to drum up billion-dollar clients, and in June, 1981, three customers called on the same day. It wasn’t a billion, but Honeywell and Gates Corp. each put $10 million in pension assets under control of the LOR system, and the Auto Club of Southern California agreed to use the program to manage $5 million worth of its insurance affiliate’s assets.
“A toe in the water,” said O’Brien.
During the next three years, business remained around the toe level as O’Brien kept trying to develop converts and the two professors refined the theory. Help came in 1982, when stock index futures were created as a way for investors to speculate on the general performance of the markets.
Leland and Rubinstein adopted the futures as means for hedging the value of a portfolio without actually selling the underlying stocks and moving to T-bills. Selling index futures in a downward market would be a faster and cheaper means of providing portfolio insurance.
Milestone Day
Under the new system, as stocks fell a specified amount and approached the “floor” of losses established by the customer, the LOR computer instructed clients at various points to sell futures contracts, usually tied to the Standard & Poor’s 500-stock index.
Those who sell futures contracts are making a bet that the stock market will go down. If the market goes down, the value of the futures contract goes up--offsetting the decline in the value of a portfolio of stocks.
Armed with a new system, O’Brien hit the bricks and had another milestone day on March 30, 1984.
Manville was searching for a way to protect the principal of its pension fund and remain fully invested in the market. Its benefits director put the entire $350-million pension fund into an LOR program. The same day, Gates decided to move from T-bills to futures for its hedging and upped the amount involved to $100 million.
“That day started things seriously,” said O’Brien.
Manville turned out to be the first of many corporate pension fund sponsors to purchase the LOR strategy. The new popularity also brought a new partner: First Interstate Bancorp of Los Angeles purchased 20% of the firm in July, 1984.
Competing firms, among them J. P. Morgan & Co. and Chase Manhattan, began to enter the field with their own systems. By last summer, an estimated $61 billion was managed under various portfolio insurance techniques.
But LOR remained the top firm, signing up such mega-clients as Aetna Life & Casualty, which manages $18 billion worth of assets under the firm’s hedging strategy; TWA; Wells Fargo, and Nikko Securities of Japan.
LOR charges annual fees in two basic ways. A company can hire the firm as investment manager for its assets. Or a company can lease the technology and manage its assets itself. The latest figures show that LOR managed $6 billion directly and that companies using its system managed $24 billion.
On Leading Edge
But, as a privately held corporation, LOR’s annual revenues are not public knowledge, although industry sources place them at $7 million or $8 million. Only in the past two years or so has the business begun to pay off nicely for its founders.
Leland and Rubinstein have retained their teaching posts at UC Berkeley, where Raymond E. Miles, dean of the business school, described them last week as “top-level people who are both on the leading edge of research and leading edge of practice.”
Both men spend at least one day a week in the Los Angeles office, but they have spent considerably more time there since Monday, Oct. 19.
The unprecedented plunge drove many LOR portfolios toward their loss floors before the system could respond. Then, as the computer caught up, it spewed out sell orders in multimillion-dollar bunches that could not be accommodated in orderly fashion by the overheated markets.
The sell orders involved varying amounts of both futures contracts and actual stocks, depending on the formula used by each fund. Critics say the aggregate effect, however, increased pressure on markets already declining rapidly--a pressure that built with each new fall of the market until it reached the “meltdown” level.
As the market collapsed, futures prices fell even further and faster than stocks. Computerized program trading began to kick in, with other big institutional investors seeking to make a profit on the difference between stocks and futures--by automatically selling stocks and buying the lower-priced futures. The computerized selling of stocks pushed stock prices even lower, contributing to a dangerous downward spiral for both futures and stock prices.
But not everyone followed the computer’s urgent instructions to sell on Monday.
“Up until that moment, LOR had done what we thought it would do--it had provided us with protection if the market was going down,” said Thomas V. McKernan, chief financial officer for the Auto Club of Southern California, which had $110 million under LOR’s system. “But when the huge sell signal came Monday, I was worried about the bounce, and we overrode the computer and waited to sell into the stronger markets on Tuesday and Wednesday.”
The potential for “bounce,” or whipsaw as others call it, had been an element of criticism of portfolio insurance for some time. Basically, the danger comes in selling into a declining market and incurring losses and trading costs. When the markets bounce back the following day, stocks must be bought on the rise, which also costs money and means the portfolio does not get into the market until it has already gone up enough to trigger the computer’s buy order.
Surprised by Speed
LOR had contended that the potential for losses from market reversals was small and part of the “premium” paid for the insurance. But no one had counted on the steep bounce of the markets that followed the crash on Oct. 19.
Another surprise for LOR was the speed of the market’s fall, which meant the volume of futures trades vital to the successful hedging could not be executed.
“We became well aware that you cannot hedge in markets where you cannot transact,” O’Brien said.
LOR sold 2,000 futures contracts on the S&P; 500-stock index on Oct. 19, equivalent to about $250 million. O’Brien said they needed to sell at least three times that many contracts to get the intended level of protection.
Ironically, the system’s inability to execute trades was cited by O’Brien and Leland as a defense to counter critics who claim portfolio insurers contributed to the market’s plunge with their programmed sell orders.
“To the extent that anyone who sells during a falling market could be said to contribute, we were amongst the sellers and we did,” said Leland. “But my preliminary evidence is that the group of portfolio insurers that we work with were not a substantial fraction of the market on Monday.”
Leland and O’Brien expect the final evidence to absolve portfolio insurance as the culprit in the crash. O’Brien even anticipates a business boom once the dust settles, explaining: “People who have lost 20% of their investment don’t feel like they need less protection.”
