Constant Proportion Portfolio Insurance (CPPI)

Constant Proportion Portfolio Insurance (CPPI) is the name given to a trading strategy that is designed to ensure that a fixed minimum return is achieved either at all times or more typically, at a set date in the future.

The difference between CPPI and standard fixed participation methodology

Unlike a standard structured product which places a set amount in a zero coupon deposit on day one and purchases a call option with the remaining funds in order to provide a set participation level, a CPPI based structure varies cash allocation between so-called safe assets (ie bonds and cash) and the performance assets (equities or other ‘risky assets’) depending upon market performance.

The key difference between CPPI based capital protected products and option-based products are:

• The participation in any rise in the underlying is not fixed at the start
• It is possible to have a higher initial participation than with an equivalent option-based product

How CPPI operates

Essentially the strategy involves continuously re-balancing the portfolio of investments during the term of the product between performance assets and safe assets using a set formula or mathematical algorithm. CPPI is totally rules based and non-discretionary.

Principal protection is achieved by adjusting the exposure to the performance assets such that the underlying portfolio (ie the mix of safe assets and performance assets) is able to absorb a defined decrease in value before the value of the portfolio falls below the level required to achieve principal protection. 

The asset allocation process is designed to allow investors to participate in rising equity markets while protecting capital in downward trends.  On a daily basis the CPPI provider will determine the allocation between cash and equities to ensure that at least 100% of capital is returned at maturity. The reduction in value which the underlying portfolio can absorb is referred to as the cushion. The size of the allocation to the performance asset will be determined by a multiplier the size of which will be related to the volatility of the asset class of the performance asset. Therefore, in practice, the allocation to the performance asset will be equal to the cushion times the multiplier.

Over time, as the value of the performance assets rise so more of the portfolio is placed in these assets but conversely as they fall in value, more of the portfolio is placed in the safe assets. By following the rules set out by the strategy the minimum return can be achieved as long as the value of the performance assets does not fall too sharply. In this case, the product provider may not be able to adjust the allocation quickly enough to stay in line with the prescribed formula which would result in a loss (to the product provider, not the investor).

What is Gap Protection?

Banks that provide CPPI underwrite this so-called ‘Gap Risk’ and guarantee to stand by the stated minimum return whatever occurs in the market. A non-bank provider of CPPI product would typically purchase Gap Protection from a third party in order to maintain their Minimum Return Guarantee.

Why product providers use CPPI

CPPI is a highly flexible method of managing risk. This technology enables product providers to offer protection on a wide range of underlying investments where a typical zero plus option strategy would not be possible. Dynamic protection is most commonly used with funds or baskets of funds where the provider is able to offer the fund performance plus a predetermined level of capital protection. Indeed, this technique is now widely used in protected open-ended fund structures where the dynamic nature of CPPI enables the provider to offer both capital protection and also a rolling profit lock-in whereby, for example, the provider can guarantee from day one that the product will be worth at least 80 per cent of the highest daily fund NAV.