CPPI structures return
Constant Proportional Portfolio Insurance (CPPI) has had a long history and is a strategy that has elements in common with both 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 when markets declined to restrict losses.
CPPI products have made something of a comeback in 2024. According to data from structuredretailproducts.com issuance volumes have already exceeded the total for 2023. Top markets by volume are Japan, Germany, China and France.
Understanding CPPI
The CPPI strategy can be thought of is 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.
There are two main variants of CPPI strategies: fixed maturity and open ended. Both variants have the concept of a “floor” (protected level), this can be based on the initial level or a proportion of the highest level reached. 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.
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 ratcheted up over time.
Pros and cons of CPPI strategies
The main advantage of CPPI is that any tradeable risky asset can be used. 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. At any time the fund’s assets are held in the risky asset or cash, and not in any derivative instruments, which can be an advantage in certain wrappers. It also allows for a variety of solutions including more modern index-based approaches.
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. This happened spectacularly during the stock market crash of 1987.
Going below the floor level is counter to the aims of the strategy and what investors have often been promised. To counter this risk “crash protection” can be bought from an investment bank. This equates to buying a daily series of deeply out of the money options. This will give the investor the protection they require however buying tail risk is quite expensive and it causes further drag on performance.
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 fully invested in cash, hence the term cash locking. This is particularly a problem in a low-rate environment as has been seen in recent years.
CPPI methodology has now been mostly supplanted by controlled volatility indices as a 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 option risk and create protected products of ten years or more.
CPPI in different markets
However, CPPI products still have a niche following and one example from the French market was launched by retail banking group La Banque Postale in 2021 (SRP id 41748448). This four-year product is set to mature in December 2025. It invests in Equities, bonds and cash in proportions dictated by the CPPI strategy. It aims to return at least 80% of the highest value reached over the four-year term. Given such a short horizon and in times of low interest rates at launch there is moderate scope for positive growth.
A similar product (SRP id 14529155) was launched in 2017 by Fund and ETF group Amundi. The Funds Protect 90 aims to lock-in 90% of the highest value reached over the five-year term.
Both these products come from retail and fund groups. A recent example from a regular structured product issuer comes out of the Irish market. Issued by Societe Generale and distributed by Cantor Fitzgerald the Technology 85% Progressive Protection Bond (SRP id 39472017) is a slightly different construction and has a continuous lock-in at 85% of the highest value reached on an open-ended basis. This is a more natural CPPI product specification as it more closely aligns with the open-ended fund concept.
Other variations exist such as the USD Target Plus (SRP id 8643012). Issued in Japan by Credit Agricole Life Insurance Japan it is a continuous insurance product linked to a managed fund investing in stocks and bonds. It is distributed by Bank of Tokyo-Mitsubishi UFJ. If the value of the investment reaches 10% bands at the end of each year, then the growth amount will be locked in and transferred to the general account in JPY, the safety asset. The investment period is 10 years.
This final example shows the variation of ideas and techniques that straddle structured products and quantitative fund strategies. These approaches can provide a variety of solutions in different markets.
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