Constant Proportional Portfolio Insurance (CPPI) has had a long history in the investment world as a proposition that straddles structured products and managed funds.
The idea of CPPI originally came out of portfolio insurance, popular in the 1980s when early program trading algorithms moved an equity portfolio steadily into cash in a rules based way when markets declined, with the idea of protecting that portfolio by steadily reducing exposure to restrict losses.
The widespread use of this technique was accused of making the October 1987 stock market crash worse than it might have otherwise been since the wave of automated selling caused the market to fall further in the fateful two days in October of that year by a feedback effect.
Despite this less than stellar origin, the use of CPPI emerged in various markets and was popular particularly in 1990s and 2000s. The strategy can be thought of a as a self-constructed capital protected structured product. Almost all CPPI investments select a single risky asset such as a fund or portfolio and a risk-free asset such as cash or high grade short dated bonds. The risky asset provides the participation and the risk-free asset the capital protection component. How much of each is needed depends on the performance of the risky asset much like a structured product’s payoff depends on its underlying asset(s).
There are two main variants of CPPI strategies: fixed maturity and open ended. Both variants have the concept of a “floor” (protected level) and they calculate the difference between the current fund value and the floor, this is defined as the cushion. A fixed multiplier (where the constant proportion part of the name comes from) dictates the amount invested in the risky asset. For example if the current fund value is 100, and the floor is at 80, then the cushion is equal to 20. If the multiplier is 4 (a typical value) then the amount to be invested in the risky asset is 20 x 4 = 80. If the fund declines in value down to 90 then the cushion amount will only be 10 and thus 40 should be invested in the risky asset.
The floor level represents the lowest value that the investor should receive. Typically, fixed maturity products set a single floor applicable at the end of the term, whereas open ended versions set a floor which can be reassessed upwards on a rolling basis. For fixed maturity products, the floor is set at perhaps 90% or 100% depending on the product maturity and interest rates. For the open ended version, 80% of the maximum fund value to-date is typical. In the fixed maturity case, in order to calculate the cushion and therefore amount invested the discounted value of the floor value at maturity is used, analogous to reserving the price of a zero coupon bond in a conventional structured product.
The main advantage of CPPI is that any risky asset can be used, provided that trading is possible and at low transaction costs. The whole strategy does not necessarily need to be run by an investment bank and has been employed by insurance companies as low risk or protected fund solutions, often alongside the direct or unprotected version of the same asset or fund.
The two main disadvantages of CPPI are gap risk and what is termed cash locking.
Gap risk means that the strategy breaks down when the market moves suddenly in a crash scenario, as it is often not possible to execute the moving of the risky asset part of the portfolio into cash quickly enough and therefore the whole portfolio falls below the floor value. In the example of a fund value of 100 with 80 invested in the risky asset and 20 in cash with a floor also of 80, as soon as the fund declines part of the portfolio should be moved from the risky asset to cash. However if the market suffers an instantaneous fall of 30% before any rebalancing can be done then the fund value will be at 70% x 80 +20 = 76, which is below the floor level.
Since going below the floor level is counter to the aims of the strategy, “crash protection” can be bought from or budgeted for by an investment bank. This equates to a daily series of deeply out of the money puts. However buying tail risk is understandably quite expensive and it causes further drag on performance and rather defeats the purpose of a self-directed strategy run by an entity like an insurance company.
Cash locking occurs when the fund declines continuously over time and even with disinvestment being done in an orderly fashion as intended the portfolio ends up almost wholly within cash to protect the floor level. This makes it very hard for the strategy to ever show subsequent gains because the product is not invested in the risky asset, hence the term cash locking. This is particularly a problem in a low rate environment.
Decline in popularity
With the exception of some insurance channels which have not chosen to adapt to newer techniques, CPPI has rather fallen out favour. Recent examples over the last ten years include AXA in France, UniCredit in Austria and Germany, KBC in Belgium and Barclays in the UK, source www.structuredretailproducts.com.
CPPI methodology is now thought of as rather simplistic with some major flaws. Low or controlled volatility and variance indices provide a much more accepted and transparent way to control risk. Many examples exist in all major markets and are available in low cost ETFs. With increased competition, better liquidity in options markets and more sophisticated trading systems, banks have become happier to take longer term risk and create products of ten years or more which also address the maturity profile that CPPI was seeking to target.
A version of this article has also appeared on www.structuredretailproducts.com