The CFA program is great for getting a wide survey of techniques you might want to add to your investing toolbox. Today’s material is based on Volume 6, Reading 45, Section 3.3.3 of the CFA Level III 2011 Curriculum.
We all know the tenets of the most basic asset allocation. Pick the desired % you want in stocks and bonds (say 60/40), invest that amount in each, then periodically rebalance back to that target. The mechanical balancing forces you to be a contrarian, in that you trim back your stock position after a bull run when they’re probably starting to get expensive, and vice versa during a bear market. Makes sense, right?
Then in the CFA Level 3 material, I encountered constant proportion portfolio insurance (CPPI). I read the first couple of paragraphs on it, stopped, and shook my head. “Wait, I must have misunderstood. It sounds like they’re saying buy MORE stocks when the market goes up, and sell when the market goes down”.
I read it again. That was EXACTLY what they were saying. A faint wail drifted in on the breeze, from the direction of Ben Graham’s grave…
And yet, there’s actually some logic to CPPI. Let’s look at a couple scenarios.
Scenario 1: the market goes into a secular downturn. If you use a traditional 60/40 constant mix of stocks and bonds, you’ll end up periodically selling some bonds to buy stocks. That all sounds smart, but what if… What if the market is going to zero?! Answer: Days before the final armageddon, where you used to have $60,000 in stocks and $40,000 in bonds, you’ll now have $6 in stocks and $4 in bonds. You’ve bought all the way down.
Scenario 2: the market goes into a secular upturn. Again to maintain the 60/40 mix, you’ll periodically take money off the table by selling some stocks and buying bonds. How very disciplined of you, but what if… What if the market goes on to double, then triple, then quadruple?! Answer: have I told you about the person I know whose cost basis in AAPL is $4? What if I’d convinced her to sell at $8 because “it is becoming too big a part of your portfolio and increasing your standard deviation”?
The mechanics of CPPI are simple. Let’s assume a $10,000 portfolio…
(1) Pick the value you never want your portfolio to fall below. ($9,000)
(2) Pick a low to mid single-digit multipler. (5)
(3) The amount in the market at any time should be the multiplier times the difference between the current portfolio value and the minimum value: 5 x (10000-9000) = 5000
(4) The remainder is put into cash or safe bonds: 10000-5000 = 5000
Check out that resulting portfolio! $5000 in stocks and $5000 in bonds. And we’re supposed to be confident it will never fall below $9000? What the …?!
Let’s work through 3 historical scenarios to understand. We go to a traditional financial advisor. We tell him that we have $10,000 to invest but we might need as much as $9,000 on short notice any time in the coming year. However, we hate to just keep it all in cash. Is there some way he could invest our $10,000 – safely – and still be highly confident that just about whatever the market does, at least $9,000 should be there whenever we need it?
He guides that the stock market can do crazy things in the short term. He could put it all in the market and buy put options for insurance, but the cost will probably be an immediate 3-5% hit to the portfolio. He’ll instead keep your $9K liquidity requirement in cash, and put $1K in the market. The $9,000 will always be there if you need it, and you will both sleep well at night knowing that. You can’t really have your cake and eat it too, after all.
CPPI would say, “Never, in all my days on God’s green earth, have I seen such cowardice masquerading as strategy. I can give you REAL market exposure AND watch your back. Have the courage to consider my approach. Remember, we are not descended from fearful men.”
Now suppose that 1-yr time frame turned out to be 2007. Look at the returns in the black boxes below. It turned out to be a small up year, but CPPI returned a bigger small up than 90% in cash.
Columns B and C are just implementing steps (2) and (3) above
Now suppose that 1-yr time frame turned out to be 2008. Yes, the market dropped by more than a third but we escaped with our $9,000 as promised.
Finally, suppose that 1-yr time frame turned out to be 2009. It was a sizable up year, and CPPI gave you a decent piece of that return.
Well I hope you’re impressed so far, but if you want to really be impressed start playing around with CPPI over 3 and 4 year periods of continual positive returns (like 1995-1999). What eventually happens is that the amount CPPI tells you to put in the market is more than the value of your portfolio. If you assume you have an unconstrained credit line and the cost of borrowing is cheap, you’ll end up seeing cumulative returns like these:
Should we end with some criticisms of CPPI? You might argue that all the rebalancing could get expensive. But just as with 60/40, you can let things drift (a little bit) and only make adjustments when you’re getting far off track.
What else could go wrong? A big gap down overnight – or really over any period where you can’t respond quick enough. If, like Dev, you like your multiplier high and your cash… down… low you’re going to be paying darned close attention to what’s going on with North Korea (and probably even Vanuatu).
But what makes CPPI feel so risky, even if you use a low multiplier? Probably the semantic correlation between portfolio insurance and the crash of 1987. Oh, and the fact that no one you know is doing it.