Portfolio insurance enables investors to limit downside risk while allowing some participation in upside markets. There are a large number of methods of portfolio insurance. The most widely used one is the CPPI (Constant Proportion Portfolio Insurance) developed in the 1980s.
The CPPI method allocates assets dynamically over time. The investment manager sets a floor equal to the lowest acceptable value of the portfolio. The manager then calculates the ‘cushion’. This is the difference between the value of the portfolio and the present value of capital to be protected at maturity.
The CPPI allows a manager to invest more than the amount of the cushion in the risk asset (equities and bonds) The investment level – the percentage invested in the risk asset – will depend on the potential variation of the risk asset. For example, if the manager believes that a risk asset can fall by no more than 20% over a week, the portfolio can be invested in five times the cushion.
The rise and fall of the cushion mechanically determines the investment level of the portfolio in the risk asset. When the value of portfolio increases, the cushion grows, generating a higher investment level. Where the value falls, the cushion decreases, lowering the investment level in the risk asset
The CPPI technique has the effect of automatically increasing investments in the risk assets when this is trending upwards. The portfolio will automatically invest less in the risk asset when this is trending downwards.
As long as the value of the portfolio remains higher that the present value of the capital to be protected at maturity – in other words, as long as the cushion remains above zero – the investment manager is always able to meet the capital return protection objective.
Degroof Institutional Asset Management and Bank Degroof Luxembourg’s financial engineering team has developed its own version of CPPI called CAPI (Capital Allocation Portfolio Insurance).
The CPPI technique is flawed, it says, because the risk asset investment level is decided by applying a fixed multiplier to the cushion. As a result divestment from the risk asset is triggered solely by a reduction of the cushion.
This has two effects in a long downtrend. The cushion will become relatively small. As a result, the investment in the risk asset portfolio will be insignificant, limiting expected performance when markets start trending upwards. Similarly in a long uptrend the cushion will become extremely large. This means that when a risk asset falls again divestment will only start when the excess cushion has disappeared, so past excess performance is not protected.
The CAPI method resolves this by using a variable rather than fixed multiplier and through quarterly protection resets. In a downtrend the CAPI will divest out of the risk asset by immediately reducing the multiplier, possibly to zero. In an uptrend the CAPI will immediately activate the maximum multiplier
DIAM says the CAPI improvements are intended to protect the cushion during a long downtrend in the risk assets and divest quickly from the risk asset in a market turn, following a long uptrend in market prices.