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Saturday, June 8, 2013

What is CPPI? How is it different from capital protection oriented funds?

CPPI means Constant Portfolio Protection Insurance. CPPI is a more refined / advanced version of a simple capital protection strategy that is usually adopted in Capital Protection Oriented funds that we see in the market. It's aim is to try and maximise the upside from the portfolio, while sticking to the basic principle of downside protection that is a necessary feature in any capital protection strategy.
Simple capital protection strategies limit the downside - and the upside too
In a simple capital protection strategy for say a 3 year period, for every 100 rupees of corpus, the fund manager will typically buy around Rs. 75 worth of G-Secs, which over a 3 year period would grow to Rs.100, with the help of accrued interest. This 75 guarantees that the capital value at the end of 3 years will not fall below 100. With this comfort, the balance 25 is typically deployed in equities, with an expectation of beating fixed income returns over the next 3 years and thus delivering an overall marginally higher return than a conventional fixed income strategy, but with the comfort of capital protection.
Yeh CPPI maange more.....
Followers of the CPPI approach consider the above conventional strategy as inefficient, as you are hardly giving yourself much room to enjoy the upsides of the risk you are taking. Lets say equity market conditions turned out to be very favourable and your equity exposure of 25 doubles over 3 years. In this case, the 25 rupees in equity would have grown to 50 and the 75 in debt would have grown to 100, thus making the original 100 grow to 150 at the end of 3 years. This would mean quite a healthy return of around 15% p.a. over this 3 year period, with capital protection, which should keep most happy. But, proponents of the CPPI model believe that they can achieve more, especially when equity markets are so favourable.
A CPPI structure revolves around two things : (1) Use of leverage for exposure in the risky asset and (2) Constant rebalancing as a mechanism to ensure effective capital protection and continued upside possibilities. Taking the same example forward, 75 rupees will in this case too be invested in appropriate maturity G-secs which should grow to 100 at the end of 3 years. The difference lies in the way the 25 is invested.
How CPPI works in a rising equity market
The 25 rupees invested in the risky asset - equities in our example - will be invested in the F&O segment - in futures and options, which gives leverage. Assuming a leverage of 4, the effective exposure to equities is 4 * 25 = 100 and not just 25, as the money is deployed in margin money for the F&O contracts and some is kept aside to fund any mark-to-market calls.
Now, lets see how the constant rebalancing works in a manner that protects the downside while trying to capture as much upside as possible. Lets assume that at the end of 1 quarter, the equity market is up by 10%. The equity exposure of 100 (leveraged) is now worth 110. There is a 10 rupee gain on the equity segment on an investment of 25. and lets say there is a 2 rupee gain on the fixed income segment of the portfolio. The total portfolio value now stands at 75 + 2 + 25 + 10 = 112.
In the CPPI strategy, the portfolio will now be rebalanced as follows. At this stage, 77 is required to be parked in G-secs to protect the principal. The balance (112-77) 35 can now be put into F&Os, which at the same multiplier of 4, gives an equity exposure of 35 X 4 = 140, which is well above the original exposure of 100 on a base of 25. You now have 140 rupees riding on the equity market instead of 100, while getting the same amount of capital protection with the 75 rupees that has now increased to 77 with accrued interest of 2. In this manner, the constant rebalancing allows you to increase your participation in a rising market, and gives you the potential of maximising your gains without sacrificing downside protection.
How CPPI works in a falling equity market
Lets now take a reverse situation - where the market falls 10% in the first quarter instead of rising 10%. The debt component has anyway grown from 75 to 77. But the equity exposure of 100 on a base of 25, is now worth 90, signifying a loss of 10. The total portfolio is valued at 75 + 2 + 25 - 10 = 92.
When the portfolio is now rebalanced, 77 will continue to be allocated to debt. The balance (92-77) 15 is now deployed in equity F&Os at the same multiplier of 4, which means an equity exposure of 60, down from the original exposure of 100. In a falling market, the equity exposure is thus automatically reduced.
If equity markets continue to fall in successive periods, the equity component will get progressively reduced. In a worst case situation of a very sharp fall in the markets, the fund manager will get into a situation known as a cash lock - where his entire equity exposure gets eliminated due to hitting the maximum loss limit in his F&O exposures. For the rest of the portfolio period, the portfolio will now become a G-sec fund, gradually working its way up to 100, with the help of accrued interest.
Frequent rebalancing is the key to successfully implementing CPPI
The key to successfully managing a CPPI strategy is frequency of rebalancing. The more frequently you rebalance your portfolio on CPPI principles, the more likely you are of catching uptrends and participating fully as well as limiting downsides from market downtrends. CPPI strategies are widely used within structured products in our markets, for their intuitive appeal of trying to achieve both objectives : downside protection as well as riding the upside.

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