As we mentioned in our previous article “Rebalancing Strategy in Portfolio Management”, the rebalancing of investments is an essential component of the portfolio management process, in particularly given today’s highly unpredictable financial markets. A portfolio could become either too risky, or too conservative as the portfolio weight may deviate from the original strategic asset allocation ratio over time. The rebalancing process safeguards investors from overly exposed to undesirable risks by bringing the portfolio back to its target asset allocation, so that it aligns with the investor’s original investment objective and risk profile.
Constant Proportion Portfolio Insurance (CPPI) strategy is one of the very popular rebalancing strategies for both institutional and retail investors, especially among more risk-averse equity investor. As its names implies, it serves as a portfolio insurance technique that allows an investor to limit downside risk of a CPPI-insured portfolio, e.g., to protect the initial principal, whilst retaining some upside potential. However, as compared to unprotected portfolio, the upside potential of a CPPI-insured portfolio is also lowered (Gerber and Pafumi, 2000).
The notion of CPPI was first introduced by Perold (1986) for fixed income instruments and Black and Jones (1987) for equity instruments. The practice behind CPPI is to shift allocation between risky and riskless asset classes in order to ensure the preservation of invested capital. A risky asset could be from equity, hedge funds, funds, equity ETF or commodity indices etc, while riskless assets could be government bonds or money market funds etc. In rising markets, the strategy allocates more towards the risky asst while in falling market, the strategy reduces the exposure in a risky asset by placing more allocation towards the safe asset.
The percentage allocated to the risky and riskless asset class depends on the “cushion” value, which is the difference between the current portfolio value and the target floor value (i.e., the minimum protection amount), and a “multiplier” that set by the investor. The cushion indicates the percentage of the fund’s asset that may be put at risk without any effect on the level of protection, while a multiplier is used to determine the amount of risk that an investor is willing to undertake. The value of the multiplier is based on the investor’s risk profile and is usually derived as the inverse of the investor’s maximum one-day loss percentage. Multiplier values between 3 and 6 are very common, provided that the maximum one-day loss range from 15% to 35%. Therefore,
% allocation in risky assets = m x (Portfolio Value – Floor Value), where m is the multiplier and cushion equal to (Portfolio Value – Floor Value).
An example of illustrate:
Consider a hypothetical 10-year CPPI portfolio of $100,000, of which the investor decides $90,000 is the floor value and his maximum one-day loss is 33%, giving a multiplier of 3.
– The allocation to risky asset would be 3 X ($100,000 – $90,000) or $30,000 at inception, with the remainder going into riskless assets.
– If market increase after 6 months and the portfolio value reached $110,000, the CPPI strategy will now allocate 3 X ($110,000 – $90,000) or $60,000 to the risky asset, while the amount to riskless asset decrease to $50,000 from $70,000 previously.
– On the other hand, if market falls and the portfolio value decline to $95,000, then the strategy will allocate 3 X ($95,000 – $90,000) or $15,000 to the risky asset and $80,000 to the riskless asset.
– If fear grips the market, and the portfolio drops to the floor value of $90,000, the CPPI strategy will allocate all the proceeds to the riskless asset.
– By allocating more and more progressively to the riskless asset when the market falls, the CPPI strategy ensure capital protection on most occasions.
As you realized from example above, the CPPI strategy can be the most effective strategy in trending bull markets, like that of the late ‘90s, where each successive increase in equities result in the purchase of more shares. On the other hand, the strategy can provide downside protection in severe bear market too. However, in a no-trend oscillating market with severe short-term reversals, the CPPI strategy is not preferable as it basically a buying high and selling low strategy. Besides, the CPPI strategy tends to underperform unprotected portfolio if the equity market rebounds, since the CPPI structure will not participate fully due to its de-risking nature when the market drops. Another drawback of CPPI strategy is the that the portfolio could still fall below the protection floor before the manager could rebalance, especially during equity market crash.