I don’t really get the idea of constant mix strategy does not have a floor value and CPPI has a floor value.
Isn’t it as long as you have investment in bonds, you have a floor value?
Let’s say your portfolio starts with 60 equity and 40 Bond mix.
If your equity value drops by half (30), to maintain the mix, you will then retain only 20 in bonds (30/0.6)*0.4.
If your equity further drops by half (15), to maintain the mix, you will then retain only 10 in bonds (15/0.6)*0.4.
To an extreme, your equity drops to 1, to maintain the mix, you will then retain only 0.67 in bonds (1/0.6)*0.4.
What I am trying to say is, as long as your equity value is not zero, you will still have some investment in bonds, isn’t it? Then, in what situation a constant mix strategy will have no investment in bonds?
Similarly but to the opposite, you can have zero investment in bonds with CPPI strategy, right?
Let’s say your portfolio starts with 60 equity and 40 Bond mix with a multiplier of 1.2. Also, assuming boond is a risk-free asset with no return.
At the start, you will have to increase your equity allocation to 72 = 1.2(100-40). Thus, your bond allocation has to reduce to 28 = 100 - 72.
If your equity value doubled, which is (72*2) = 144 in this case. Your total portfolio value now becomes 144 + 28 = 172. Since your total portfolio value increased, your equity value should pumped up to a target value of 172.8 = 1.2*(172-28). As you can see, now the equity allocation is higher than the total portfolio value. Shouldn’t that imply no investment in bonds and thus no floor value? In other words, to increase the equity value from 144 to the target of 172.8, you need 28.8, which is more than what you have with your bond (28).
What I am trying to say is, as the market is trending upward, you have to pump-up your investment in equity. Assuming no additional funds are added to the portfolio, then you must reduce your investment in bonds in order to accommodate your target level of equity in the portfolio. In that sense, isn’t it possible at an extreme, your investment in bonds becomes zero because your target allocation to equity is too big?
CPPI’s floor value is predetermined before you make the investment. When your investment value reaches the floor value, you move all assets to cash or other very low risk liquid assets (term deposits, default-free govt bonds and so on) to secure that floor value.
note that this floor value DOES NOT EQUAL to the bond allocation and it does not change as portfolio goes up and down.
so in your example, assume that the floor is 40 and you have 100 ready to invest with a multiplier of 1.2 with equity being the risky asset. You would then allocate 72 to equity and 28 to bonds. (note that 28 is not equal to the floor being 40)
Suppose now it’s been some time and portfolio increased to 120 and you decide it’s time to rebalance with the floor still at 40. Allocation to equity is now 1.2 (120-40) or 96 and the rest in bonds (24).
Suppose a crash happens and the portfolio drops to 70. Allocation to equity is now 1.2 (70-40) or 36 with 34 in bonds.
tl;dr The allocation to risky asset is equal to multiplier x (portfolio value - floor value) with floor value being a fixed number and NOT EQUAL to bond/conservative asset allocation.
Thanks for your reply. But still I don’t get idea of the floor value. What is it exactly? Is it just a theoretical value?
Because according to your example, if the portfolio value increased to 300, and I decide it’s time to rebalance, then the allocation to equity is 1.2*(300 - 40) = 312. So does that mean I allocate 312 to equity? If that is the case, then what is my floor value? Even if I kept the floor value at 40, that would mean I have 40 in cash, 312 in equity, and thus total of 352? but obviously that number is higher than 300.
it’s a value determined by policy at the start and can be reviewed by investors/managers alike as portfolio goes up/down.
when portfolio value goes to extreme levels, then it’s a good idea to change your floor value to keep sticking to your IPS or SAA. or the other alternative is to change your IPS/SAA.
if portfolio value goes to 300 but you don’t increase the floor value, yes allocation to equity is 312 but also you allocate -12 to bonds (short) if allowed. If shorting is not allowed, then investors/managers must discuss about moving up the floor value or reducing the multiplier m.
as I said, FLOOR VALUE IS NOT YOUR ALLOCATION TO CASH/BONDS.