China's domestic stock market--also known as the A-share market--has been trading around its multi-year low of late. Chinese retail investors therefore are being more cautious with investing in the equity market. Nevertheless, the investors have few alternative investment vehicles available, as illustrated by the huge amounts retail households keep in bank savings deposits.
As a result, Chinese retail investors have shown strong interest in principal-protected investment products. These products are expected to generate better returns than those offered by the savings account in banks and, equally importantly, they provide some insurance for investment capital. Although principal-protection is a well-developed structure in more developed markets, the trading dynamics in China are different and therefore principal-protected funds in China need to consider special hedging mechanisms to achieve principal protection.
Hedging Difficulty
The most common type of principal-protected product in developed markets consists of a zero-coupon bond and an equity call option. The zero coupon bond typically has a present value of about 70-90% of the initial investment and it will have a redemption value equal to the initial investment at maturity, hence providing the capital protection. The remainder of the initial investment (minus applicable fees) is used to purchase the equity call option, which provides the upside exposure to the equity market for the investor.
In China, zero coupon bonds are scarce. Furthermore, there isn't an equity derivatives market. Without these tools, principal-protected funds in China have to rely entirely on their trading and asset allocation strategies to protect the initial investment amount. The principal protected funds launched in China are reported to use two main strategies: constant proportion portfolio insurance (CPPI) and/or time-invariant portfolio protection (TIPP).
CPPI Vs. TIPP
CPPI strategy uses mathematical modeling tools to rebalance allocations between risky assets, such as stocks, and less-risky assets, such as fixed income instruments. The risky assets portion gains a desirable exposure to the underlying market, whereas the less risky assets provide some insurance for the investment capital. This asset allocation is dynamically adjusted through the investment period.
Assume total capital is invested in two assets only: stocks and bonds. Then over time, the desired stock position is created based on the following formula:
$ invested in risky assets (stock) = M * (A F), where
M = stock investment multiplier
A (assets) = total assets held in the portfolio
F (floor) = minimum portfolio value (zero risk level)
A F = net amount of cushion or funds that can
be put at risk
Under a CPPI strategy the issuer buys more stock as it appreciates and sells when it depreciates. Bonds are purchased as the stock is sold and vice versa. The investment multiplier is typically established at a value greater than 1. When A-F =0, the portfolio will stop investing in stocks.
TIPP has the same investment amount calculation formula, except that its protection floor level (F) is not fixed at inception. The protection level in TIPP is also adjusted over time, but would be adjusted only upwards but never downwards. At any time, the new protection level in TIPP is the larger of (a) the current protection level and (b) the current asset value in the portfolio (or a percentage of asset value, e.g., 90% of A, as per investors' risk tolerance level).
Thus the protected level at adjustment period T+1 is
Ft+1 = MAX (A, Ft), where
Ft+1 = protected level at period T+1
A = total asset value at the end of period T
F t-1 = protected level at period t-1
Similarly, $ invested in stock for Period T+1 = M *
(A Ft+1)
One rationale for the adjustable protection levels is when their investors are receiving positive returns such returns (investment appreciation) should be subject to protection as well. Another reason is investors are risk-averse. When their wealth increases, the protection level should be increased as well; but when total wealth is decreasing, they typically don't want to decrease the protection level. Thus over time, the protection floor level should be adjusted, but upwards only. As such, TIPP is essentially a more conservative investment approach than CPPI.
Both CPPI and TIPP strategies are still subject to the constraints of the bond markets in China. With fairly high volatility in China's stock market, the principal protected funds need to adjust the equity and debt ratio frequently under either CPPI or TIPP strategies. The limited liquidity of China's bond markets may make it difficult to buy or sell large volumes of bonds quickly. This will be a particularly critical issue when the stock market has a significant drop, because funds need to sell stocks and buy bonds in large amounts. Hopefully, the liquidity situation will improve as more debt market financial innovations are introduced, such as the new Treasury bond buy-out repo trading on the Shanghai Stock Exchange.
Considering the limited liquidity of China's bond markets, many funds have taken a conservative approach by investing a high proportion of capital in bonds for the initial asset mix. For example, the first CPPI fund from China Southern is reportedly to have 75% of initial assets invested in bonds. In the future, Chinese convertible bonds may also become an interesting asset choice for such funds, because the unique features in many Chinese convertible bonds significantly reduce the credit risk and stock price risk in those convertible bonds (DW Learning Curve, 9/20).
Conclusions
Principal protected funds have attracted interests from Chinese retail investors who seek capital appreciation with capital protection. Due to the lack of zero-coupon bonds and option markets, many funds have reportedly adopted CPPI and TIPP strategies for principal protection. TIPP is a more conservative strategy than CPPI, but both require dynamically adjusting asset allocations (stock and bond investments) over time. The bond markets in China are not always liquid, however, thus leading many principal-protected funds to invest a high proportion of capital in bonds at inception.
This week's Learning Curve was written by Winston Ma, CFA, marketing specialist and products structurer in the equity capital and derivatives markets group at JPMorgan Securities in New York.
