Portfolio insurance is equivalent to a securities position comprised of an underlying portfolio plus an insurance policy that guarantees the portfolio against loss through a specified policy expiration date. Under true portfolio insurance, the probability of experiencing a loss is zero; the position’s return is dependent solely on the ending value of the underlying portfolio, regardless of interim movements in portfolio value; and the expected rate of return is greater than that on any other strategy possessing the first two properties.
European payout-protected puts could be used to provide perfect portfolio insurance. The investor would select a put option on the underlying portfolio such that exercising the put would yield just enough to make up for any decline in portfolio value plus the initial cost of the option. Unfortunately, European options are not available on listed exchanges in the U.S.
In their absence, portfolio insurance may be approximated by using listed options or by a systematic dynamic asset allocation strategy employing either cash and the underlying portfolio or a replicating futures position. Because the longest effective maturities of listed options are two or three months, a portfolio insurance strategy of any reasonable length will be susceptible to interim movements in the underlying portfolio, hence will generally have lower expected returns than true portfolio insurance. Dynamic asset allocation strategies designed to replicate a long-term European protect put come closest to perfect portfolio insurance.
