“It’s a trend that started two years ago,” says Bertrand Penverne, Paris-based head of structured products for France at Crédit Agricole Asset Management (CAAM), of the re-emergence of products based on constant proportion portfolio insurance (CPPI). “The main issue was that the networks were asking for products with longer offer periods, up to nine months in some cases, in addition to the traditional formula funds [option-based products with short, one or two month, offer periods and payoff defined by a set formula] where the offer period is two months.” (see chart, below).
This re-emergence is somewhat surprising, seeing as the products currently being launched are no more sophisticated than those issued in the 1990s. The only difference is that the distributors are now placing more emphasis on CPPI-based products as part of their total product offering.
A CPPI strategy, rather than investing a substantial proportion of capital at the outset in a non-risky asset such as a zero-coupon bond, references the amount of capital required to return the initial investment at the end of the product. This level, known as the floor, is therefore the discounted value of the guarantee at maturity. The difference between the floor and the net asset value (NAV), known as the ‘cushion’, is then multiplied by a gearing factor (the multiplier) to determine the level of investment in risky and non-risky assets. The multiplier itself is determined by various factors such as volatility and interest rates.
Different kind of risk
The main difference between CPPI and option-based products is that CPPI exposes investors to the realised volatility of the risky asset, rather than the implied volatility, which they would buy into from the start when the option is purchased. The type of risk to which investors are exposed is therefore quite different. “CPPI is a path-dependent structure,” says Laurent le Saint, SG’s Paris-based head of structured alternative investments. “The outcome depends on how the market performs and not really on the performance of the underlying portfolio from day one until maturity, like in an option-based product.”
The risk is therefore shared differently between the investor and the issuer. When using CPPI, it is the investor who is exposed to market volatility. With options, on the other hand, it is the structurer who takes on the volatility by selling the option.
However, CPPI does have substantial benefits for the investor. With an option-based product, the underlying assets are fixed until maturity, whereas for CPPI, the manager can reallocate the investment to take advantage of market opportunities whenever he wants. “If you think markets will be more interesting, you can adjust your multiplier and increase your activity,” says Pascal Christory, Paris-based head of structured and index products at Axa Investment Managers (AXA IM). “You are not completely free – there is a risk budget that we have to comply with. Because we cannot invest more than the cushion multiplied by the multiplier, if you decide to invest in more volatile assets, you will have to adjust the multiplier because it is dependent on the volatility,” he says. This will reduce the leverage in the investment process.
On a day-to-day basis, the approach is also more transparent. Investors can see the NAV, and early redemption is easier. In option-based products, the NAV is rarely a fair reflection of the product as generally they must be held until maturity. “With option-based products, you might have a basket that is doing well, but because of changes in interest rates the NAV might fall, and the client doesn’t understand why,” says Denis Cohen Bengio, Paris-based retail product manager at Axa IM. “We tell investors to hold it for the full five years, and not to look at the NAV.”
Another benefit is that investments can be made in much more volatile underlyings, especially funds of hedge funds. “The process is linked to the volatility of the underlying,” says Paris-based Eric le Brusq, European head of structured products at Société Générale (SG). “The more volatile the underlying the more we try to propose a CPPI-based product, which is why we think they are well adapted to hedge funds.”
For SG, most of its CPPI business is for private banks, high-net-worth investors and institutions, while option-based products dominate the retail market. And of those CPPI deals, the majority are options on CPPI.
Space for all
Although CPPI structures are becoming a permanent fixture in many distributors’ product ranges, market participants agree that CPPI is not really in direct competition with the more traditional formula funds approach. “There’s certainly room for both strategies,” says Bengio. “Axa [the insurance network] is very happy with CPPI, but it also wants to launch option-based products. Because subscription periods are shorter, from a sales perspective there are more arguments to make [the selling period] more intense and put more pressure on the sales force,” he says.
CPPI products are also appearing in response to changing tastes. At the end of 2003, Axa IM launched Multistars, an eight-year option-based product linked to a basket of managed funds. The issue raised €30 million, but Bengio says he was surprised that the formula wasn’t more successful. “We thought it would be a great success. The message was simple: 85% of the basket of funds, with capital guaranteed,” he says.
That formula was soon shelved because the investors Axa IM dealt with were not enamoured of passively managed products. “What investors want is active management, with a large leeway given to the asset manager to take bets,” Bengio says. For option-based products on managed funds, the fund has to be fairly rigidly benchmarked, which is not what people want he says. “For more actively managed funds, the only way to provide protection is to use CPPI.”
Axa IM’s most successful product during the past few years has been its Performance Confort series of CPPI-based, life insurance-wrapped products. The first three tranches sold €370 million in steadily increasing volumes, and the fourth will be the largest yet. But Bengio says there was a lack of understanding on behalf of investors with regard to how the technique works. “There were problems for people who didn’t know how CPPI worked. But the CPPI management technique was the answer to many questions from the Axa network,” he says. These included demands for guaranteed products which also had active management, flexibility, liquidity, and were able to react quickly to market shifts.
“It was a matter of explaining the technique without getting too complicated,” Bengio says. Rather than delving into the technical aspects of the product, the company simply explained how it behaved under different market conditions. It used the metaphor of a ship cautiously leaving the coast. When the ship encounters a storm, it just stops sailing forwards, continuing on its way when the storm subsides.
In a booming market, the competition is sure to heat-up. In mid-February, Sinopia, the asset management arm of HSBC-owned CCF, launched River Funds, a series of five capital-guaranteed products. They are designed with the pensions market in mind, using a PERP wrapper. All have five-year subscription periods and maturities of between one month and 25 years. The products will be invested in futures on international indexes, with their portfolios rebalanced every week.
Investors can invest whenever they want during the subscription period, after which the product strikes. However, unlike formula funds, they can redeem their money at the net asset value (NAV) at any time without having to pay a withdrawal fee. Capital is guaranteed for those who maintain their investment until maturity and the payoff is calculated as the largest of either 100% of the highest NAV observed during the offer period, or 85% of the highest NAV observed during the investment period.
“There is higher demand for such products these days,” says Paris-based Karine Desaurty, portfolio manager for CPPI products at Sinopia. The company wanted to target the pension market using the relatively new PERP wrapper. “For a 25-year product, it makes more sense to have a CPPI product because you can change the allocations during the product. With an option-based product, you are stuck,” she says, extolling the virtues of having the ability to change the asset allocation.
As with the Axa product, Desaurty notes, however, that the end investor will have difficulties understanding the product. “We don’t try to explain the technicalities of the product. What we do is explain the benefits of the guarantee and the ratchet [the guarantee on the highest level of the NAV], but not the exact CPPI technique. It’s easier to say that exposure will be higher when markets are bullish and lower when markets are not,” she says. The company also uses Monte Carlo simulations to show investors the levels of participation that might be achieved.
The main risk associated with CPPI is the danger that the product will ‘knock out’, a phenomenon related to gap risk. If there is a sharp fall in the risky investment, then, in order to maintain the capital guarantee, the asset manager has to ensure the floor is not breached by cashing out the risky investments into non-risky ones. If the fall is fast enough, this may have to be total and the investor is left holding nothing but a zero-coupon bond until the product’s maturity. In the past, many investors who bought CPPI products were not adequately informed of the knock-out risk. For instance, in Italy, the bursting of the technology bubble was significant enough to knock out many products.
Current products do, however, have the advantage of hindsight. The knock-out risk is highest at the beginning, so investment managers try and smooth this out. Desaurty says with long-dated products, it’s foolish to invest all of your risk budget in one go. “We never manage at the maximum level of exposure,” she says. Axa IM also invests cautiously to begin with. “If we invest our total risk budget immediately and markets fall, it’s a problem. So we average the market entry point to avoid market-timing risk,” Christory says.
Penverne foresees CPPI becoming a part of issuers’ main offerings, but doesn’t think it will overtake formula funds. “The big advantage of a formula fund is that there is a formula. If you make it simple enough, it’s easy to understand the scenario that will make you money and the one where you will use the guarantee the product provides,” he says.
However, for asset managers who operate in more boutique environments, CPPI is ideal. “We think that the use of CPPI is going to increase,” says Axa’s Christory. “It’s an ideal product for asset managers. Because it is actively managed, we have a competitive advantage.”