The Culprits Behind the Crash?

By Philip Elmer-DeWitt

It was billed as the high-tech investment strategy of the decade. Using computerized trading in esoteric investment vehicles like stock-index futures, the technique promised managers of pension funds or any other kind of investment pool the Wall Street equivalent of the Holy Grail: "insurance" for their portfolios against future downturns in the stock market. As the Dow Jones industrial average kept climbing to new highs through much of 1987, the value of the funds covered by so-called portfolio insurance swelled to an estimated $80 billion.

Then came Black Monday. When the market crashed on Oct. 19, so did the reputation of this hot new investment tool. Since then the assets covered by portfolio insurance have shrunk by about two-thirds. Worse, its practitioners were accused by a presidential task force chaired by Investment Banker Nicholas Brady of being primarily responsible for the severity of the crash. Says Howard Stein, chairman of Dreyfus and a member of the Brady commission: "A handful of aggressive speculators brought the market to near collapse." Robert Kirby, chairman of Capital Guardian Trust and another task- force member, comments, "They've taken our financial markets and turned them into a damned casino."

The idea behind portfolio insurance is deceptively simple. During a rising market, a fund manager pays a premium to an insurer in return for a promise that the value of his portfolio will not fall more than a specified percentage if the market takes a nose dive. Investors have long searched for such a perfect hedge, and with the advent of new investment tools in the early 1980s, & it looked as if they had finally found one. Says Hayne Leland, the Berkeley finance professor who came up with the scheme: "We felt we had a reliable instrument."

Leland's original idea, developed in the mid-1970s with the help of another Berkeley professor, Mark Rubinstein, involved a complex formula by which money managers would make swift, sharp changes in the ratio of cash to stocks in their portfolios as share prices rose or fell. The plan was workable, but because it involved buying and selling large quantities of stocks, it was also relatively cumbersome and expensive.

Enter stock-index futures. These are speculative instruments, traded mostly in the pits of the Chicago commodity exchanges, that allow investors to bet on the direction the stock market is headed without having to buy the stocks themselves. Cheaper and easier to trade than traditional securities, stock- index futures seemed to the budding portfolio insurers like a hedge made in heaven. Rather than sell stocks when prices start to fall, clients could hold the stocks and sell stock-index futures instead. If the market kept falling, income from the sale of the futures would offset much of the losses in the underlying stocks. If the market reversed field and started back up, clients would take some loss on the futures, but the value of their stocks would be higher.

Suddenly the professors had a salable product. Bolstered by the marketing skills of their new partner, a Bronx-born investment consultant named John O'Brien, portfolio insurance took off. By 1984, Los Angeles-based Leland O'Brien Rubinstein was insuring hundreds of millions in assets. Two years later, the firm had licensed its strategy to half a dozen investment counselors, including Wells Fargo Investment Advisors and Aetna Life Insurance, and the value of covered assets had grown to some $45 billion.

So what happened on Oct. 19? Basically the scheme was undone by its own success. When the stock market began to dive, all the portfolio insurers started selling futures at once. As the price of the futures collapsed, the stocks followed suit. That triggered further selling by the portfolio insurers, reinforcing the downward spiral. One of the biggest, Wells Fargo, sold $1.6 billion in futures on Black Monday alone. This was more than the market could absorb. Says Capital's Kirby: "It's like a guy driving into a parking lot with the Queen Mary and asking, 'How come these guys haven't provided a space for me?' "

In their defense, portfolio insurers point out that their combined actions accounted for only 20% of the volume on Oct. 19. "You can't blame us," says Eric Seff, a managing director of Chase Investors Management, a division of Chase Manhattan Bank. In fact, much of the damage on Black Monday was done by a small group of fleet-footed traders who could see the insurers coming and rushed to get out of the market ahead of them. Says Fred Grauer, chairman of Wells Fargo's investment unit: "The preponderance of selling activity was in the hands of others."

The one thing the technique did not do on Black Monday was provide total insurance against a crash. One deeply insured investment fund, the pension plan of U S WEST in Denver, watched the value of its stock holdings shrink from $3.3 billion to $3 billion. Although the company estimates it might have lost an additional $400 million had it not been covered, it no longer insures its pension funds.

Regulatory action could make it much more difficult to use portfolio insurance in the future. Last week the New York Stock Exchange announced an experimental ban on certain computer trades when the Dow rises or falls 75 points or more in a single day. Moreover, both the Chicago Board of Trade and the Chicago Mercantile Exchange have imposed daily limits on how much the prices of stock-index futures can fluctuate. But even the Brady task force says it would prefer to let the marketplace make its own decision about portfolio insurance, rather than try to ban it outright. As Robert Gordon, president of Twenty-First Securities, puts it, "You can't outlaw a strategy."

With reporting by Thomas McCarroll/New York and Charles Pelton/San Francisco