| Constant Proportion Portfolio Insurance (CPPI) 101 |
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| 18/06/2006 | |
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Denis Cohen-Bengio, Head of Investment Solutions Product Specialists at AXA Investment Managers, answers this week's 101 on the CPPI 1-What is the CPPI strategy? What is its purpose for an institutional investor? The Constant Proportion Portfolio Insurance (CPPI) technique is a portfolio management strategy that follows a mathematical algorithm designed around 1976, allowing investors to benefit from potential market gains, while protecting a percentage of the original investment or return, or having a full guarantee on the investment. In order to protect or guarantee the capital at maturity, the asset manager implements an active strategy called the CPPI guidelines, consisting of a daily rebalancing between risky and non-risky asset classes. The dynamic allocation between these two asset classes depends on the performance of the market: rising markets favour the exposure to risky assets, whereas falling markets lead the asset manager to increasing the weight of non-risky assets. In case of a heavy and repeated market slump, the CPPI fund can lead to a cash-out event and would be invested in fixed income instruments till maturity. The advantages of the CPPI methodology are that an investor benefits from a managed capital guarantee while participating in the upside of an underlying asset. Furthermore, the CPPI behaviour during the life of the product allows increased participation in the underlying in rising markets while limiting the loss in decreasing markets. 2-What kind of institutional investor can / should include this type of strategy in their portfolio? Thanks to the high degree of customisation they offer, CPPI funds are suitable for all kinds of clients. Investing in CPPI products benefits any institutional investor who is looking for portfolio diversification, as the inclusion of a CPPI fund helps to improve the risk-return profile of a classic portfolio. For example, pension funds might benefit from such a strategy as CPPI technique allows one to structure repayment flows coupled with a capital guarantee or protection, helping to match assets and liabilities issues (in such cases, the CPPI bond floor being the present value of liabilities). Moreover, the CPPI methodology allows exposure in attractive underlying assets (equities, multi-strategy funds, credit derivatives, trackers etc.) without carrying the full risk, as the capital is protected or guaranteed at maturity. It is then interesting to gain exposure via the CPPI framework to already performing asset classes which investors fear might have reached their highest market value. These same products are also useful in order to increase diversification via the exposure, in a capital guarantee format, to a particular asset class which is not directly easily available otherwise (i.e. gold, volatility, correlation…). In addition, tailor-made CPPI products combine several characteristics that are different to traditional asset classes (type of underlying, maturity, protection or guarantee, specific lock-in features or coupon distribution etc.). In summary, ad-hoc products help to customise investors' specific risk-return needs. For example, they can provide leverage to an investment in order to maximise potential gains or simply bet on specific market scenarios (decrease in stock markets, rise in interest rates etc.). Finally, the CPPI guidelines allow some room for active management techniques in order to match asset allocation needs. 3-What are the alternatives to such a strategy? An alternative to such a strategy is the investment in passive/formula/option-based products. Formula products allow clients to participate, via the purchase of an option, at a fixed percentage of potential performance for a specific underlying asset, while benefiting from capital protection or guarantee at maturity. The performance of the fund, defined by a formula, has a known in advance behaviour. Products can be customised in order to match specific risk-return profiles, but in this case the upside potential is not unlimited but fixed at start as a percentage of the risky underlying assets. |
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