Constant Proportion Portfolio Insurance (CPPI)

Constant proportion portfolio insurance (CPPI) is an investment strategy that aims to protect a minimum portfolio value, called the floor, while keeping some exposure to a risky asset such as shares. It does this with a simple rule and no options: the amount held in the risky asset is always a fixed multiple of the cushion, the amount by which the portfolio's value exceeds the floor. The rest is held in a safe asset such as cash or government bills.

The method was set out in the mid-1980s by André Perold and by Fischer Black and Robert Jones. It is a form of dynamic asset allocation and has been used widely in capital-protected funds and structured notes.

The rule is:

• $E$ is the exposure, the amount to hold in the risky asset.
• $V$ is the current value of the whole portfolio.
• $F$ is the floor, the value the investor does not want to fall below.
• $m$ is the multiplier, a constant greater than one chosen at the start.

The difference $V - F$ is the cushion. The remainder, $V - E$, goes into the safe asset. The floor is usually set so that it grows at the safe interest rate to reach the protected amount at the end of the term. Exposure is normally capped at the portfolio's value unless borrowing is allowed.

An investor has $100, sets a floor of $80 and chooses a multiplier of 4. The cushion is $20, so the risky exposure is 4 × 20 = $80 and the safe holding is $20.

The risky asset falls 10 percent. The risky holding drops to $72 and the portfolio to $92. The cushion is now $12 and the target exposure is 4 × 12 = $48. The investor sells $24 of the risky asset, leaving $48 risky and $44 safe.

Had the risky asset risen 10 percent instead, the portfolio would be worth $108 and the cushion $28. The target exposure of 4 × 28 = $112 exceeds the portfolio's value, so without borrowing the investor would hold the full $108 in the risky asset. In both cases the rule buys after gains and sells after losses.

CPPI is a trend-following rule in effect. In a market that rises steadily it adds exposure on the way up and can outperform a fixed mix of shares and cash. In a market that falls steadily it cuts exposure early and holds close to the floor. Its weakness is a market that swings back and forth with no direction. Each fall triggers a sale at a low price and each recovery triggers a purchase at a higher one, and the repeated round trips wear the cushion down. Transaction costs from frequent rebalancing add to the drag.

This profile is the opposite of a constant-mix strategy, which sells after rises and buys after falls and so does well in oscillating markets. Higher volatility generally hurts CPPI, in the same way that it raises the cost of buying a put.

The floor holds only if the investor can trade before the cushion is used up. With a multiplier of $m$, a single fall in the risky asset of more than $1 / m$ between rebalancing points wipes out the cushion. In the example, a multiplier of 4 means a drop of more than 25 percent before the next trade would push the portfolio through the floor. This is called gap risk. It arises when markets fall sharply overnight or when trading is halted, as in a stock market crash.

The second weakness is cash-lock. After a large fall, the cushion is close to zero and almost everything is in the safe asset. If the market then recovers, the portfolio has little or no exposure and cannot take part.

• Protective put. Buying a put option on the portfolio gives a contractual floor with no gap risk, at the cost of the premium. CPPI pays no premium upfront but its cost shows up as lost upside in choppy markets.
• Option replication. The portfolio insurance of the 1980s copied a put by delta hedging with index futures. Its forced selling into a falling market is widely cited as a factor that deepened the crash of 19 October 1987. CPPI shares the feature of selling as prices fall.
• Volatility targeting. Volatility targeting scales exposure by recent volatility instead of by distance from a floor, and sets no minimum value.

A ratcheting floor rises as the portfolio reaches new highs, locking in part of the gains; one version is known as time-invariant portfolio protection. Some designs vary the multiplier with market volatility, lowering it when conditions are turbulent.

Banks and asset managers have packaged CPPI into funds and notes that promise the return of capital at maturity, with the safe asset often a zero-coupon bond maturing on that date. The guarantee in such products depends on the creditworthiness of the provider, and the protection usually applies only at maturity. An investor who sells early receives the market value, which may be below the protected amount. The strategy limits loss relative to the floor; it does not prevent a maximum drawdown from the portfolio's peak down to that floor.