In the past decade many alternative assets, such as hedge funds and commodities indices, have proved to offer an attractive yield to investors compared to traditional asset classes. However, the public perception of alternative assets is that they are risky and volatile. Pension fund trustees and sponsors, who bear the fiduciary duties, are hesitant to include them in the list of choices for their members. Using tools like a constant proportion portfolio insurance (CPPI) wrapping of these alternative assets, or even traditional asset classes, can be very effective, owing to a combination of capital protection and the use of leverage. The latter ensures there is sufficient exposure to the underlying asset to meet or enhance the original expected yield of the chosen asset class. From an asset allocation standpoint, the expectation is that CPPI will expand the efficient frontier of investment choice.

Figure 1 shows how a CPPI, structured on an extremely well-diversified fund of hedge funds, provides higher returns in combination with a lower standard deviation, when compared to the hedge fund index risk/return profile. There is no doubt that trustees and fund sponsors would be attracted to this idea, of using a capital protected mechanism to wrap asset classes they originally were reluctant to offer, due to fear of the unknown.

How can CPPI improve the efficiency for defined benefit pension schemes? For a DB scheme, the mismatch between the duration of assets and liabilities has been highlighted to be one of the biggest risk factors in the pension fund portfolio. The typical DB pension fund asset portfolio normally consists of equities and/or real estate as the asset classes used to diversify and enhance the yield of the portfolio and reduce the level of future contributions from the fund sponsor.

However, equities, real estate or alternative asset classes for that matter, do not contribute any duration to the asset portfolio. If empirically any interest rate sensitivity has been found, it will not be stable. In other words, higher yielding asset classes exaggerate the mismatch position in the context of duration-matching exercises like liability-driven investment.

One or a series of structured CPPI notes, with a chosen long maturity, can be designed to lengthen the asset portfolio to match the liability duration. At the same time, it will also safeguard or enhance the expected return, by the leverage of the underlying asset classes. To visualise the benefit, in figure 2, a comparison of the distribution of possible returns on an equity index is compared to the distribution of a CPPI on the same equity index.

 

Structuring CPPI on risky asset classes, like funds of hedge funds, will provide liquidity and increased risk monitoring that investors will benefit from, since banks running the gap risk on these underlyings need to be comfortable with the underlying exposures.

A much-heard argument against the use of CPPI is the risk of ‘cash out'. From an institutional investor point of view, there may be no a risk at all. CPPI and the capital protection can be seen as a flexible management tool. The structures typically provide a ‘redeem and renew' strategy. The ABN Amro FI Solutions Group performed stochastic analysis on the Singapore STI index to see what the change in risk/return profile might be.

The driving assumption is that, if a cash-out occurs, the look-back period is 10 days. If the equity index level is at the same level as 10 days before or better, the CPPI note would redeem and restart. The new CPPI note would define the protection level at the then prevailing net asset value. The term is defined to be either the remaining maturity or another 15 years. The results are shown in figures 3 and 4. The reference to 15/100/4 means the term is 15 years, the guarantee is 100% of principal, and the multiplier is 4.

To redeem and restart, the note with an adjusted principal guarantee like that shown in figure 3, provides a slightly improved average return compared to the ‘static' CPPI, with a comfortable probability to end up above the original principal, as shown in the CVAR statistics.

Hence, the results show that the risk of a cash-out is not a risk from an institutional investor perspective, if you have the ability to redeem and restart the investment. A similar conclusion can be drawn from figure 4, based on renewing for the remaining term.

 

A last demonstration of the benefits of CPPI in an ALM context is the following. Our UK pensions advisory team has conducted simulations to show how a portfolio with CPPI (with equities as the underlying asset) measured against a standard equity/bond portfolio (figure 5). Three portfolios are chosen to show on how the funding ratio changes over five years. These are:

n 60% equities, 40% bonds

n 30% equities, 70% liability-matched

n
20% CPPI risky portion, (2:1 leverage) 80% liability-matched.

For simplicity, it is assumed that the initial funding ratio is 1.00 and no contributions are made in the interim five-year period. The CPPI has the 2:1 leverage described above and it is maintained when CPPI value is greater than its initial value.

The simulation result is remarkable. By allocating 20% in a risky portion of CPPI with two times leverage, a fund can achieve:

n
the same level of downside protection as 70% liability-matched/30% equities;

n
similar upside potential as a 40% bonds/60% equities allocation.

We think this clearly demonstrates that structuring in CPPI can extend the choice and improve the efficient frontier to the members of a pension scheme with capital protection, without sacrificing the exposure to higher return. Further, it also provides a solution to managing the mismatch risk of assets and liabilities, and that cash-out risk is less applicable in an institutional investor perspective.

George Coppens is vice-president of ALM Solution at ABN Amro in Hong Kong