Stock protection funds (also called protection funds) are a marriage between modern portfolio theory and risk pooling/insurance that may help such investors. MPT demonstrates that, over time, there will be substantial dispersion in individual stock performance. Risk pooling makes it possible to cost-effectively spread similar financial risk evenly among participants in a self-funded plan designed to protect against catastrophic loss. By integrating these key principles, protection funds provide downside protection akin to that of at-the-money or slightly out-of-the-money European-style put options, but at a fraction of the cost.
Protection funds permit investors to retain full ownership of their shares, including all of their stocks' upside, while mutualizing only their stocks' downside risk. Investors, each owning a stock in a different industry and seeking to protect the same notional value of stock, contribute a modest amount of cash (not shares, which they can continue to own) into a fund that will terminate in five years. The cash is invested solely in U.S. Treasury bonds that mature in five years, and upon termination the cash is distributed to investors whose stocks have lost value (on a total return basis).
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Losses are reimbursed using a "reverse waterfall" methodology until the cash pool is depleted. If the cash pool exceeds the aggregate losses (70 percent probability), all losses are eliminated and the excess cash is returned to investors. If, on the other hand, the aggregate losses exceed the cash pool (30 percent chance), large losses are substantially reduced.
The shares being protected are not touched. Investors can continue to own their shares, or they can sell, gift, pledge, borrow against or otherwise dispose of them at any time during the five-year term of the fund.