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Protecting Portfolio Value: Constant Proportion Portfolio Insurance Versus Tail Risk Hedging

Tail risk hedging seeks to protect gains without loss of upside equity potential.

Many investors are nervous after nine years of U.S. economic expansion and rallies that have sent most asset prices to record levels. What strategies can seek to protect gains without losing exposure to risk assets that may continue to appreciate? Two common approaches are constant proportion portfolio insurance (CPPI) and tail risk hedging (TRH). Although both have merit, our historical analysis suggests that TRH may be the preferred strategy given low interest rates and low implied volatility in equity markets.i

CPPI is a low-cost trading strategy that attempts to protect principal and maintain equity market upside potential. It’s been popular historically, especially among more risk-averse equity investors. To seek these seemingly incompatible objectives, however, compromises must be made.

Consider a typical CPPI structure that has a five-year investment horizon, aims to provide a minimum return of 85% of principal at maturity, and maintains initial participation in the equity market at the same level as if the investor had simply invested directly in stocks (i.e., 100% participation). As time passes and market conditions change, the exposure to equities adjusts dynamically to attempt to protect the targeted minimum 85% return of principal at maturity. In practice, if the equity market falls from its initial level, the strategy reduces (and potentially eliminates) its equity exposure – a path-dependent approach.

Investors typically implement CPPI for a five-year term, with the initial investment divided into two accounts:

  • A safety account, often invested in short-term government securities, which aims to provide the target minimum return of principal at maturity, and
  • A risk account, which contains the balance of the investment and collateralizes the equity market exposure. The beginning equity exposure (taken via futures) is equal to 100% of the total strategy investment, with maximum leverage of five times. As a result, the account can withstand as much as a one-day 20% equity sell-off.ii

This paradigm implies a minimum starting value of 20% in the risk account, with no more than 80% in the safety account. Therefore, given today’s low interest rates, the target minimum return of principal at maturity must be lower than 100%, because the 80% invested in short-term government securities for five years won’t provide enough return to reach 100%.

CPPI dynamically reduces the loss from risk-off events by reducing equity exposure as markets fall, which occurs quickly due to the leveraged nature of the risk account and the ample liquidity of the futures market. Clearly, rapid de-risking is beneficial in a sustained sell-off because it reduces losses as the market moves lower.

There is a potential drawback, however. If the equity markets rebound, the CPPI structure will not participate fully due to this de-risking (an example of the path-dependent nature of CPPI). This was the case during the 2008 financial crisis, when a hypothetical CPPI strategy (over the five-year investment horizon) would have underperformed the S&P 500 for several years. Effectively, when the strategy de-risks in a crisis, it has “locked-in” some or all of its losses, because there is less participation in a post-crisis rally.

Tail risk hedging

TRH, in contrast, attempts to put a floor under portfolio losses in a risk-off event without requiring investors to reduce their equity investments. It does so by purchasing out-of-the-money (OTM) put options on primary portfolio risk factor exposures such as the S&P 500. Typically, investors will bear a certain amount of first loss (e.g., a 15% loss at the portfolio level), but TRH aims to protect their portfolio against further losses. The OTM put options reduce risk in a sell-off, enabling the underlying portfolio to remain fully invested in risk assets.

However, this flexibility comes at a cost: The TRH strategy requires an annual premium on put options (similar to an insurance premium), and in flat-to-up equity markets, most or all of the value of these put options will decay. During risk-off markets, however, the TRH strategy is expected to buffer the portfolio against losses, and may be worth multiples of the premium spent.iii (See Figure 1.)

Notably, CPPI did not provide a substantial return improvement over unhedged S&P exposure during any of the crisis periods after 1990. Five years was sufficient for markets to recover from the sell-offs.

TRH, on the other hand, substantially outperformed during the global financial crisis (GFC). Admittedly, TRH performance was weaker during the tech bubble, perhaps because the strategy was modelled as one-year S&P 500 puts, rolled at the end of each calendar year. This approach has limitations, in particular its inability to capitalize on within-year drawdowns (as happened several times during the tech bubble).

In post-crisis periods, CPPI lost its return advantage over TRH. Intuitively, this may be because lower interest rates increase the amount deposited in the CPPI safety account, reducing the loss buffer in the risk account. A substantial sell-off therefore causes the structure to de-risk. And as we have seen, if the market subsequently rebounds, then CPPI will likely lag due to its path-dependent nature.

Time for TRH

Given these patterns, today’s low interest rates and muted equity volatility suggest that investors looking to defend gains in their portfolios may find TRH more appealing. As noted, amid low interest rates, CPPI structures have very little time during a sell-off before they are forced to de-risk, potentially forgoing some or all participation in a subsequent market rebound. Moreover, with the VIX (and hence option costs) now near 20-year lows, the cost of tail risk hedges is low.

This low cost, combined with strong historical performance in a crisis and the ability to participate in a rebound, may make TRH a better choice than CPPI for most investors today.

Figure 1 is a diagram comparing relative experience of tail risk hedging (TRH) strategies versus constant proportion portfolio insurance (CPPI) strategies. The graphic shows three boxes vertically stacked on the left, one up top, representing the pre-crisis period of 1995 to 2001, one in the middle, representing 2001 to 2012, which included the tech bubble and global financial crisis, and a third box on the bottom, representing the post-crisis period. Each box corresponds with descriptions in box on the right-hand side of the diagram. The descriptions are detailed within.

The figure is a table that details the rolling five year returns for the S&P 500 Index (SPX), the SPX with constant proportion portfolio insurance, or CPPI, and the SPX with active tail risk hedging, or TRH. The table also includes performances for the sub periods of pre-crisis, crisis, and post-crisis. Data is detailed within.

The figure is a bar graph showing the rolling five-year performance of the S&P 500 outright, the S&P 500 constant proportion portfolio insurance, or CPPI, and the S&P 500 with SPX with active tail risk hedging, or TRH. The graph covers the period 1995 through 2016. Up through 2001, returns for all three are similar, with outright S&P 500 strategy slightly outperforming one with CPPI, and the one with TRH trailing slightly behind. Rolling five-year returns in those years ranged from about 10% to 28%. Returns were similar 2013 through 2016, ranging between 10% and 18%. The chart also shows how only in the years 2008 through 2012 did the strategy with TRH show better five-year rolling returns than that of using S&P 500 alone, or with CPPI.



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i Low levels of equity implied volatility ( e.g., as measured by the VIX Index) make the cost of protective equity puts low as well.
ii A one-day sell-off in excess of 20% would cause losses greater than the balance of the risk account, so money would need to be taken from the safety account to cover these losses. This risk, combined with the uncertain return from its investments, explain why the safety account may not be able to deliver its targeted minimum return of principal.
iii According to CBOE and Bloomberg data ended 31 December 2016, over the past 21 years the TRH premium spend averaged about 1% annually for a 60/40 portfolio with a 15% maximum-loss target, based on PIMCO’s historical analysis of the average cost of a one-year 25% OTM SPX put. During substantial risk-off events, payouts on these options have ranged from two to 10 times the cost of the option.
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Michael Connor

Derivatives Strategist, Quantitative Strategies

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Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value.  Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk.

The scenario analysis involves asset or portfolio modeling techniques that attempt to simulate possible performance outcomes using historical data and/or hypothetical performance modeling events.  These methodologies can include among other things, use of historical data modeling, various factor or market change assumptions, different valuation models and subjective judgments. Hypothetical examples are for illustrative purposes only. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown. Hypothetical or simulated performance results have several inherent limitations. Unlike an actual performance record, simulated results do not represent actual performance and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated performance results and the actual results subsequently achieved by any particular account, product or strategy. In addition, since trades have not actually been executed, simulated results cannot account for the impact of certain market risks such as lack of liquidity. There are numerous other factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results.

There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve. 

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