Portfolio Insurance: What it is, How it Works

What Is Portfolio Insurance?

Portfolio insurance is the strategy of hedging a portfolio of stocks against market risk by short-selling stock index futures. This technique, developed by Mark Rubinstein and Hayne Leland in 1976, aims to limit the losses a portfolio might experience as stocks decline in price without that portfolio's manager having to sell off those stocks. Alternatively, portfolio insurance can also refer to brokerage insurance, such as that available from the Securities Investor Protection Corporation (SIPC).

Understanding Portfolio Insurance

Portfolio insurance is a hedging technique frequently used by institutional investors when the market direction is uncertain or volatile. Short selling index futures can offset any downturns, but it also hinders any gains. This hedging technique is a favorite of institutional investors when market conditions are uncertain or abnormally volatile. 

This investment strategy uses financial instruments, such as equities, debts, and derivatives, combined in such a way that protects against downside risk. It is a dynamic hedging strategy that emphasizes buying and selling securities periodically to maintain a limit of the portfolio value. The workings of this portfolio insurance strategy are driven by buying index put options. It can also be done by using listed index options. Hayne Leland and Mark Rubinstein invented the technique in 1976 and it is often associated with the Oct. 19, 1987, stock market crash.

Portfolio insurance is also an insurance product available from the SIPC that provides brokerage customers up to $500,000 coverage for cash and securities held by a firm. The SIPC was created as a non-profit membership corporation under the Securities Investor Protection Act. The SIPC oversees the liquidation of member broker-dealers that close when market conditions render a broker-dealer bankrupt or put them in serious financial trouble, and customer assets are missing.

In a liquidation under the Securities Investor Protection Act, SIPC and a court-appointed trustee work to return customers’ securities and cash as quickly as possible. Within limits, SIPC expedites the return of missing customer property by protecting each customer up to $500,000 for securities and cash (including a $250,000 limit for cash only).

Unlike the Federal Deposit Insurance Corporation (FDIC), the SIPC was not chartered by Congress to combat fraud. Although created under federal law, it is also not an agency or establishment of the United States government. It has no authority to investigate or regulate its member broker-dealers. The SIPC is not the securities world equivalent of the FDIC.

Benefits of Portfolio Insurance

Unexpected developments—wars, shortages, pandemics—can take even the most conscientious investors by surprise and plunge the entire market or particular sectors into free fall. Whether through SIPC insurance or engaging in a market hedging strategy, most or all of the losses from a bad market swing can be avoided. If an investor is hedging the market, and it continues going strong with underlying stocks continue gaining in value, an investor can just let the unneeded put options expire.