Constant proportion portfolio insurances (CPPIs)

Constant proportion portfolio insurances (CPPIs) are long-term investments, and few static trading strategies can generate consistently high returns for 7 to 10 years. A manager can improve the returns on a CPPI strategy by:
■ Selecting portfolios that go long credit with high spreads for their risk or go short expensive credits. This can be done using fundamental credit analysis or models such as Citigroup's hybrid probability default (HPD) model.
■ Spotting distressed credits early to avoid credit events (downgrades or defaults).
■ Positioning for credit curve steepening or flattening by selecting different maturities for credits in long/short trades.
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If allowed by the CPPI structure, a manager could switch from one strategy to another during the life of the trade if he believes that it is in the interest of investors. For example, in a credit/equity trade, it may make sense to go long credit and short equities when companies are deleveraging and use most of their cash flow to reduce their debt, but then to reverse that strategy when companies start increasing dividends and carry out share buybacks. Having a manager has a cost, and each structure will be different. Investors should assess whether the benefits listed earlier outweigh the cost of the manager.
When Is Constant Proportion Portfolio Insurance (CPPI) Suitable?
Thanks to the greater liquidity of the CDS market, Constant proportion portfolio insurance (CPPI) products are now offered to credit investors. While these trades can be attractive due to their principal protection and high target returns, investors should be conscious that their choice of trading strategy, leverage level and mechanism, and the maturity of the trade are all key factors determining the performance of their investment. By selecting portfolios, avoiding defaults, and potentially changing the trading strategy during the life of the note, a manager can add value. Its actual benefit should be assessed by comparing the added value to the cost of the manager. Overall, we think simple trading strategies are most appropriate for a Constant Proportion Portfolio Insurance (CPPI) setup as they suffer from lower transaction costs, are less likely to be affected by a liquidity crunch, and are easier to structure in large sizes.
Choice of Trading Strategies
There are a number of trading strategies that can be employed in Constant proportion portfolio insurance (CPPI). Simple long strategies can appeal to investors who are bullish on credit risk or who believe that spreads compensate them adequately for bearing default risk. Some examples of strategies might include:
■ A 5-year long-only credit trade.
■ A 10-year long-only credit trade.
■ A 5-year constant maturity CDS (CMCDS) versus CDS trade.
■ A 10-year versus 5-year long/short trade.
■ A long stock versus short 5-year credit trade.
The following case study compares the five different strategies in an unlevered setup, outside of the Constant proportion portfolio insurance (CPPI) structure, in order to examine its impact on the performance. Our results from the case study show that a simple structure, either a simple long or a long 10-year/short 5-year, exhibit better overall performance. Those strategies have several key advantages. First, they are straightforward and do not add an already complex strategy to the sophistication brought by the dynamic leverage structure. Second, they can be done in relatively big sizes because the CDS market is liquid, in particular for index names (iTraxx and CDX). This liquidity, in turn, minimizes transaction costs, which are a concern for Constant proportion portfolio insurance (CPPI) strategies due to the frequent rebalancing of the trade.

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