Downside Protection

Tony Robbins has a terrific new book on winning the financial game (“Money: Master the Game”). The highlight of the book is a series of interviews with famous investors, in which Robbins extracts valuable insights into the strategies of the successful. The primary lesson is “don’t lose money” and the second “don’t forget lesson number 1.” The fundamental lesson of financial theory is that the best strategy for accomplishing this is to diversify your portfolio across asset classes and individual securities. Robbins recognizes and supports the value of diversification, but he places even more emphasis on “an unbelievable new tool to present downside risk.” The unbelievable new tool is “structured notes” that are designed to guarantee return of principal while at the same time enabling the purchaser to participate in upside movements in price of a risky asset, like stocks or gold. Basically, what this is a long position in a call option which has been packaged into the structured note by a bank or other financial institution. Robbins does not point out that the investor can accomplish the same objective by buying the call option directly, and avoid fees and expenses charged by the seller of the note. This failure to mention is surprising given that in another part of the huge tome (620 pages), the author goes on at length about the deleterious effects of large fees on investment performance.

The idea of eliminating downside risk is surely attractive. It is analogous to purchase of insurance for your car or your home. You pay an insurance premium to avoid the risk of major loss. In the case of options, the premium is the cost of the option if you buy it outright, or the embedded fees and costs of the structured note if you buy the note. A major difference with normal auto or life insurance, however, is that across the population these risks tend to be independent, so that an insurance company can fairly precisely estimate total losses and build these losses into the insurance premium. The problem with insurance on the overall stock market, or other broad asset class, is that the risk is systematic and cannot be diversified. The sellers of the structured note will protect themselves by purchasing call options in the market. But this requires someone else to sell the calls and absorb the risk of a major market move. This will probably not be a big deal, unless Tony’s book is hugely successful and tens of millions of investors surge to buy these structured notes (call options). In that case this would necessarily create a very large short position in calls. This could be de-stabilizing.

Tony’s product is somewhat analogous to “portfolio insurance” that was very popular in the 1980s. Portfolio insurance was created by two finance professors at the University of California at Berkeley, Hayne Leland and Mark Rubinstein. Leland and Rubinstein teamed up with a market guy, John O’Brien to form the company LOR. LOR’s idea was to offer to institutional equity investors a “synthetic put” – aka, insurance policy – on their portfolios by taking short positions in stock index futures contracts. The basic idea was to use options pricing theory to determine the appropriate short futures position to protect the portfolio against market declines. There was a clearly defined trading strategy to accomplish this which involved selling more futures contracts after stock prices fell, and buying futures back after stock prices rose.

The product turned out to be extremely popular and the total value of portfolios insured by LOR or copycat firms was approximately $100 billion by 1987 (this was a big number back then). Everything was cool until October of that year when stock prices began falling sharply during the first half of the month. This decline called for portfolio insurers to sell large amounts of stock index futures. The stock market decline continued, and perhaps accelerated due to the forced selling of futures contracts. This culminated on October 20 in an unprecedented drop in stocks of 23% in one day (the “Crash”). Massive attempted sales of index futures drove futures prices well below their “fair value” relative to the stock index, and the floor values were breached. Not only that, but when the market rebounded the next day, the insured companies failed to participate in the upside. In subsequent investigations by the SEC and others, it was determined that selling by portfolio insurers was at minimum a significant factor in extending the size of the crash.

Portfolio insurance as created through a synthetic put was discredited, but the demand for protection against market declines was enhanced. This shows up today in a significant price premium in out-of-the-money put prices. People still want to own protection, but sellers are only willing to provide this at elevated prices (insurance premiums).

Ultimately, the people who provide the insurance to Tony’s readers will need a strategy to protect their own positions. The nature of this protection is a trading strategy like LOR’s; namely, buy the index after prices rise and sell after prices fall. Presumably, the lesson of 1987 has been learned and not yet forgotten, so the cost of Tony’s insurance incorporates an appropriate risk premium. This should dampen the appeal of Tony’s strategy, but if it does not and the strategy becomes massively popular, then the probability of another major market dislocation increases.

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