Portfolio insurance can protect a portfolio from declining in value during down markets; in up markets, however, an insured portfolio will not increase in value by as much as a comparable uninsured portfolio. This loss in upside capture represents the most important cost of portfolio insurance. It is sensitive to many factors, some of which can be controlled by the investor. The investor can, for example, reduce the cost of portfolio insurance by (1) lowering the floor return of the insurance strategy, (2) decreasing the percentage of the portfolio’s assets covered by insurance, (3) increasing the risk (beta) of the underlying portfolio or (4) extending the insurance strategy’s horizon beyond one year.
The investor should also be aware, however, of other factors that are beyond his control. A decline in the risk-free rate, for example, will decrease the implicit return available in the hedged portion of the portfolio, hence increase the cost of insurance. Similarly, an increase in the return on equities relative to the risk-free rate will increase the cost of insurance. Increased volatility of the risky assets will also raise insurance costs by increasing the likelihood of “whipsaw” movements that force the portfolio into selling as the market drops and buying as it rises.
Finally, an insurance strategy, by increasing portfolio turnover, tends to increase transaction costs. Careless trading or market illiquidity translates directly into reduced return, hence increased cost.