Evolution of Portfolio Insurance

Leland had come to realize that the local arbitrage argument used by Black and Scholes to price options could be extended to actually create options. Rather than create a risk-free return by dynamically hedging an option with stock, as in Black-Scholes, why not reverse the process and create an option by dynamically hedging the stock with a risk-free asset?

During the summer of 1978, while working in France, Leland saw a possible resolution to the volatility problem. The Black-Scholes formula had several arguments: the strike price, time-to- expiration, the interest rate, and the variance of the stock return. But time and variance always entered as a single term, multiplied together. This meant that if the variance were higher, all pricing and hedging would remain identical if the time period were shorter! With a little more math, Leland realized that exact insurance could be provided, if what was insured was a total volatility, which could be expressed as a predetermined number of moves of the underlying portfolio.

So Leland-Rubinstein Associates' first product was portfolio insurance for a given number of moves of the underlying portfolio. Our sales presentation contained an example in which protection was provided for five moves (any combination of ups and downs) of 5%. The protection was good until the maximum number of moves had occurred. By specifying the term of the insurance in this manner, we did not have to worry about excessive costs or mishedging. Increased volatility would simply result in quicker expiration, at which point (we hoped) the client would renew his policy.

To demonstrate that the system worked in the real world, Rubinstein actually used the system on his own account, shifting money between Vanguard's Index Fund and Money Market Fund. The experiment was a complete success and formed the basis for results later reported in Fortune magazine (June 1980).

Leland went home and eagerly waited for the phone to ring. It never did. In our quickly diminishing naiveté, it was difficult to understand why such an appealing idea as portfolio insurance would not be immediately picked up by someone. It seemed if we didn't run into the stone wall of disbelief that it was possible to create portfolio insurance, we ran aground on the old conservative argument: "If this is so good, why isn't someone already doing it?" Worst of all were the silent types who would nod with approval and apparent understanding during our whole presentation, but never tell us their reservations. As familiar as this response may be to many salespeople, this was new to us academics who never had to go far among our colleagues to find an argument.

Characteristically, standing on his faith in the power of a good idea and his ability to sell it, O'Brien was willing to give up his safe and comfortable position at Becker and throw in with us. An agreement was reached in the fall of 1980 and Leland O'Brien Rubinstein Associates, Inc. (now mercifully known as LOR) was incorporated in February 1981 with three principals, two part-time secretaries, one computer, and no clients.

Within a month, however, we had our first client. MidContinent Capital Management, headed by John Mabie, insured a $500,000 account for six moves of 4%.

we had our first major problem. MidContinent's second program, also for six moves of 4%, did not last the six months which average volatility would imply. The market fell with higher-than average volatility. The program delivered as promised⎯but the moves had expired more quickly than projected⎯the program was completed after only four months. And, while providing protection against losses as we had expected, the program's early termination had unsettled the client.

We had our first competition from two well-established firms. Ironically, neither firm met with much success but inadvertently helped to legitimize the product in the minds of many firms who later became our customers.

Our first account using index futures was started in March 1984. As of the end of 1986, roughly 80% of the dollar value of LOR accounts was protected using futures.

In 1983, we began to attract large money managers as licensees. Because our software was soon transferred from the IBM 5100 to its successor, the IBM/PC, its portability meant that our product could be used in a truly distributed computing environment. Our software allows certain functions to be performed locally and others to be performed on a PC-based time-sharing system run out of our offices in Los Angeles (with a complete backup system in New York in case California falls into the sea).

The sophistication of portfolio insurance users has grown as rapidly as the product itself. Currently, more than 75% of LOR accounts are not run with traditional Black-Scholes hedging. Rather, time-invariant or "perpetual" programs are used. These programs have the advantage that there is no fixed expiration date: The program can be left in force as long as the client wishes. And, in another development, sponsors are realizing the advantage of programs that protect a fund's surplus. Portfolio insurance is being applied to many different classes of assets besides equities; fixed-income and international investments are growing areas of application.