Constant proportion portfolio insurance - Playing on protection

Constant proportion portfolio insurance (CPPI) techniques have long been used to protect investors' principal on equity-based structured products. However, with some CPPI products performing poorly during the stock market sell-off in May and June, dealers are putting more effort into alternative mechanisms. By Duncan Wood

The big selling point of constant proportion portfolio insurance (CPPI) products has always been the guarantee on investors' principal. So, when global stock markets nosedived in May and June, buyers of these products wouldn't necessarily have been worried about losing their savings. There are other risks, however. Variously dubbed 'cashing out', 'locking out' or 'monetisation' by those in the game, traditional CPPI products come with an inherent risk that the performance component of the product will evaporate in the face of a sliding stock market, leaving investors holding a capital guarantee, but nothing else.

CPPI works by dynamically rebalancing cash between risk-free assets (for instance, government bonds) and risky assets (such as equities), with the aim of ensuring that the amount invested in fixed income is sufficient to repay 100% of the investor's principal at maturity.

The technique works by selecting a floor, below which the portfolio value is not allowed to fall, and the cushion (the portfolio value minus the floor) determines how much money is invested in equities to generate returns. The exposure to stocks varies as the portfolio value changes, so if the stock market falls, cash is pulled out of equities and a greater proportion is invested in fixed income to ensure that the redemption amount is in line with that promised to the investor. If the portfolio value hits the floor - the minimum level required to provide the guarantee - the investor would effectively be left holding a zero-coupon bond for the remainder of the product's life.

The global stock market sell-off in May and June served as a timely reminder of this inherent risk. The S&P 500 index fell by 7.7% between May 5 and June 13, while the UK's FTSE 100 index dropped by 9.8% between May 9 and June 14. A handful of dealers claim some recent CPPI products were hit hard, with a few close to cashing out.

This kind of thing has happened before. "Weaknesses in the basic CPPI model were first highlighted in 2002, when a number of products sold in Ireland and Italy cashed out," says Robert Benson, managing director at Arete Consulting, which owns the website structuredretailproducts.com. Dealers have spent the past four years trying to ensure the same thing wouldn't happen again.

In some cases, the basic CPPI process has been given a relatively simple tweak - for instance, adding a reservoir of accumulated profit that can be used to take on fresh equity exposure if the product performs badly. In others, the product has been fundamentally altered, to the extent that it is barely recognisable as CPPI - and innovation at this end of the spectrum continues at a furious pace.

Private bank SG Hambros is due to launch the first tranche of its new dynamic capital protected portfolio (DCPP) product later this month (see box), which Andrew Popper, the bank's London-based chief investment officer, describes as a next-generation CPPI product. "It combines the advantages of traditional CPPI with the advantages of an options-based structure and a volatility capping mechanism," he explains.

Products that marry options with CPPI are not new - neither are volatility caps - but SG Hambros claims the DCPP structure is the first to combine these features while also offering active management of the underlying assets. "The reality is that successful CPPI structures need to be managed. Just putting the product on auto-pilot is a recipe for disaster if there is a sell-off," says Martin Brookes, deputy chief investment officer at SG Hambros. "We've certainly seen growing interest from clients who are dissatisfied with the poor management of CPPI they've experienced at other firms."

Other houses have also seen strong demand for CPPI variants that aim to be more resilient to market sell-offs. One of the most common modifications is the addition of a minimum equity exposure. In this structure - as in traditional CPPI - a sustained slide in stock markets would cause the product to rebalance, with cash flowing out of the equity portfolio into the risk-free assets. But the modified product incorporates optionality that provides minimum equity exposure of, say, 20%. The fact that the product has retained an exposure to equity gives investors a chance to benefit if the market rebounds.

Different banks have their own names for this kind of structure. BNP Paribas calls it an option on a dynamic basket (ODB) and claims to have transacted hundreds of millions of dollars in this product over the past four years. JP Morgan calls it synthetic portfolio insurance (SPI). In both cases, there are no physical assets underlying the option. Instead, the option is linked to a synthetic portfolio that references the official closing prices for stocks, net asset values for funds or swap rates. This synthetic portfolio is then treated in exactly the same way as a physical portfolio, with simulated rebalancing as the reference prices change. "Economically, SPIs are the same as a physical CPPI, but you may benefit from a whole range of additional features that are not possible in standard CPPI, including minimum equity exposure," says Lucia Pelliccioli, vice-president for equities exotics and hybrid trading at JP Morgan in London.

For dealers, the key advantage of these CPPI-option hybrids is that the hassle of buying and selling actual stocks is removed at deal level, becoming a book-level problem that can be managed more efficiently. A lot of the fixed costs associated with traditional CPPI disappear, allowing the bank to offer small, bespoke deals to wealthy individuals or smaller institutions. Clients, meanwhile, know that even if markets slide, they won't end up holding a zero-coupon bond.

But combining a capital guarantee with the promise of minimum equity exposure leaves dealers exposed to risk. In traditional CPPI, the formula ensures there is always enough invested in the risk-free portfolio to return 100% of capital at maturity. In an SPI or ODB structure, however, it's conceivable that maintaining an exposure to equity at all times could lead to losses. This is a risk that the dealer bears, says Pelliccioli: "You delta hedge it like you would any option."

These hybrid forms of CPPI have themselves been further modified to produce a wide array of products. "By using options, you have the great advantage of being able to mix worlds between option strategies and straightforward CPPI techniques," says David Moroney, a director in equity derivatives structuring at Barclays Capital in London.

As an example, he cites a hybrid CPPI product, which gives investors the ability to choose between the better of two payouts at maturity - either the CPPI performance or an option struck at the trade's inception. In volatile markets, best-of products have an advantage over CPPI-plus-option products - in the latter, exposure to equity may be floored anywhere between 10% and 20%, meaning a zig-zagging market may drag the equity allocation down to the floor before rebounding, and investors "may miss a late term rally due to a low allocation to the risk asset", he explains.

But is all this complexity necessary? Two of the best-selling CPPI structured products in the UK in recent years have been the open-ended Protected Profits offered by Zurich Financial Services (ZFS) and structured by Barclays Capital, which has raked in over £1.8 billion across three funds, and the fixed-term Guaranteed Investment Plan, offered and structured by HBOS, which was launched in November 2003, also raising close to £2 billion. Neither structure is options-based. Neither suffered unduly in this year's sell-off.

"Even after the market movement, the product had over 50% allocated to equities," says Peter Davis, fund development director at ZFS in Swindon. He says he finds it difficult to imagine the company embracing some of the more complex products being offered by dealers: "Professionals can get round the table and be comfortable with these things, but ultimately these products are sold to customers through distributors, and part of the success of our product is that it's really easy to understand."

Davis accepts that it is possible for Protected Profits to cash out, but says it would take a single-day stock market fall in excess of 30%. And the absence of options does not mean these products are defenceless in the face of market volatility - both ZFS and HBOS say significant volatility would cause the company to step in and start pulling money out of equities more rapidly than usual.

Derek Borland, a senior product manager at HBOS in Leeds, says: "We looked at the threat of cashing out and if volatility hits an extreme spike, we exit equities quicker than you would normally expect. That cash would then be used to buy futures and options to gain exposure in the event of the market coming back. It can't ever cash out completely - there's always some equity exposure."

THE NEXT STEP IN CPPIT

The latest arrival is dynamic capital protected portfolios (DCPP) - a product that SG Hambros has been working on for six months along with the equity derivatives team at Societe Generale Corporate and Investment Banking. The aim was to create a product that would combine the active management of CPPI with the security of an options-based product.

The bank plans to launch the product in mid-October, and Martin Brookes, SG Hambros' deputy chief investment officer, says the first tranche will raise around £30 million. Over the next three to six months, "we'd be pretty disappointed if we hadn't raised £100 million" with follow-up tranches, he says.

Superficially, the product structure is pretty simple: most of the money is invested in a zero-coupon bond that provides a 100% capital guarantee at maturity. Alongside that, a call option is linked to an actively managed fund of funds and a target asset allocation is agreed on, with monthly investment decisions taken by SG Hambros. However, these investment decisions are accompanied by a volatility cap set at 10%. On a daily basis, the volatility of the fund of funds is calculated and a simple calculation performed. "We divide the level of the cap by the one-month historical volatility of our target asset allocation - the result of this calculation will be the exposure of the fund of funds to our target asset allocation," explains Alex Zimmermann, a senior portfolio manager responsible for ultra-high-net-worth and family office clients at SG Hambros in London.

As an example, if the volatility of the assets is 10% on a given day (equalling the level of the cap) the funds would be fully exposed to the target allocation. If volatility increased, the allocation would be adjusted until it falls within the cap - riskier assets would be wound down and less risky assets would be beefed up. A spike in volatility to 20% would see a 50% exposure of the fund of funds to the target allocation. A drop in volatility to 5% ought to see the fund of funds taking on leverage to boost the exposure to 200% - but SG Hambros has capped the leverage that can be used so exposure will not go above 150%, says Zimmermann.

This volatility capping regime has the dual benefit of protecting investors and boosting the product's upside potential. Because the writer of the call option knows that the volatility of the underlying is capped at 10%, the premium is relatively cheap. As a result, SG Hambros is able to provide equity participation of 95%. Without the volatility cap, participation would only be 70-75%, says Zimmermann.