Theory and practice of portfolio insurance

To achieve their goals, many investors are allocating towards more risky assets. In many cases, these investors can quickly find themselves in a tight spot if the risk budget is not expanded accordingly. This is where portfolio insurance can come into play. But, which strategy proves to be most effective?

Jul 2, 2017 | Invesco Quantitative Strategies team

In brief

To limit the maximum loss of a portfolio, investment strategies can be enhanced by adding a portfolio insurance component. We have analyzed various portfolio insurance strategies – from the static stop-loss concept to option based strategies and dynamic portfolio insurance strategies. The findings suggest that an active approach on the basis of dynamic risk forecasts is an effective alternative.

In order to achieve their performance goals, many investors are allocating towards more risky assets. In many cases, these investors can quickly find themselves in a tight spot if the risk budget is not expanded accordingly. This is where strict risk control via portfolio insurance can come into play. But, which portfolio insurance strategy proves to be most effective in historical simulations?

Investors’ objectives are generally expressed as a combination of risk and return targets. Defining the return target is usually relatively simple – but the definition of risk targets is less straightforward. One conventional approach is to consider “volatility”, that is, the average variation of portfolio return over time. For many investors, however, “maximum drawdown” is a more relevant statistic, as it points to the maximum loss of value. To limit the maximum drawdown, investors typically follow broadly diversified investment strategies that include a tactical asset allocation component designed to avoid losses as often as possible.

However, to effectively limit maximum drawdown, a given investment strategy could implement some form of portfolio insurance. Portfolio insurance strategies aim primarily to improve the downside risk profile of an investment without jeopardizing long-term return potential. In this article, we will present various portfolio insurance strategies and analyze their strengths and weaknesses.

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