Investment portfolio insurance is a bit like life insurance: You get protection against financial catastrophes, but you pay a premium for it. There is a tradeoff in the form of either higher costs or limited upside participation in exchange for peace of mind. To figure out if this tradeoff works for you, let's look at three examples:
These investments can offer 100 per cent principal protection in worst-case scenarios, offer higher than normal GIC returns in some situations, and they can be collapsed by your provider if the markets are on a tear. It's clear that the tradeoff you are making is the guarantee of at least getting your money back in case the market tanks, but you won't fully participate in the upside of the market during a bull run. Your returns are range bound. Keep in mind that when these are most desirable (right after a market crash that gets everyone worried), that's also when they are most likely to be called away during their subsequent term.
Think of segregated funds as mutual funds with an insurance policy wrapped around them. You can get guarantees on the principal (maturity of these guarantees is usually 10 or 15 years or to age 65) and guarantees on death at any time. Some would argue that a return of 0 per cent over 10 or 15 years is unlikely in the market, and that is true, but it has happened. I know many advisers who became very popular with their clients for having them in segregated funds before the credit crisis hit. You effectively pay a premium for this insurance in the form of a higher MER for a similarly mandated mutual fund. Note also that the cost of the premium is correlated with the volatility of the mandate. A Canadian fixed-income segregated fund will have a lower premium than an emerging markets equity segregated fund. The more likely you are to cash in on an insurance benefit, the higher the premium will be. Note that there are other benefits of segregated funds over and above mutual funds that need to be factored into the cost-benefit analysis.
Put options and equity collars
Buying a put option on a stock you own guarantees you a floor price. Specifically, owning a put option gives you the right, but not the obligation, to force a sale of the underlying stock for the length of the option term. For example, if stock XYZ is trading at $100 a share, you could purchase a put option with a strike price of $85 a share. If stock XYZ fell to $50 a share, you could exercise your right to force a sale at $85 a share. Your loss is limited to $15 a share plus the cost of the put option and trading commissions. For some, this cost may be too high and they can in turn sell someone else a call option with a strike price of $120 a share. A call option gives you the right, but not the obligation, to purchase an underlying investment at the strike price. In this case, this would be advantageous to the call option holder if XYZ was trading above $120 a share. However, note that we are selling this call option to someone else and we collect a premium to give someone else this privilege. This premium can help offset the portfolio insurance aspect of buying the put option. Also notice that we have range bound the stock to between $85 and $120.
As you get closer to retirement, portfolio insurance strategies become more important as you may want to protect against a possible black swan event when your portfolio is at its largest value. When you are younger, or your portfolio is smaller, you have more of an ability to recover. The extra cost of insurance can add up over longer periods of time. As with many insurance products and strategies, you want to start looking at them for the purposes of guarding against catastrophic losses, not easily overcome hiccups.
Preet Banerjee is the W Network's Money Expert and a senior vice-president with Pro-Financial Asset Management. His website is wheredoesallmymoneygo.com.