Very often the fear of undefined downside risk prevents many investors to either stay away from risky asset classes like equity completely or have sub optimal allocation to them. If there was a way to define the downside, many investors would find it comfortable to increase their allocation to equity to an optimal level.
Various methods have been adopted to contain the downside to a desired level. The most common methods are Stop Loss, Purchase of protective put and Option Replication or CPPI (Constant proportion Portfolio Insurance).
Stop Loss is the most simple and most commonly used method. However, it is unscientific and based on the gut feel. Purchase of a protective put option is a very sound and watertight strategy but often the put option is not available for a longer duration. Buying series of short term put options may increase cost. In such a scenario option replication or CPPI becomes the best option to define and contain the downside risk of a portfolio and at the same time have significant upside exposure.
CaPPS is a PMS scheme based on a quantitative model. The main objective of the model is to have a defined downside and unlimited upside based on performance of the underlying portfolio. To achieve such a pay off structure, the model uses principal of option replication by dynamically hedging a portfolio based on CPPI model. In laymen's term when the value of underlying asset rises the allocation to equity rises and vice versa.
Exposure in underlying equity will replicate index. The index exposure will be taken through Basket of equity shares, futures, ETFs or combination of three.
The investors can select floor levels of either 90% or 80% of principal and they can also select automatic rebasing of floor at every 10% rise in NAV.
Upside participation ratio will broadly depend on the protection level selected. More aggressive investor i.e. those who have chosen an 80% preservation level will have higher participation and one with 90% preservation level will have lower participation.
What are the risks ?
The level of preservation is not a guarantee.
The actual NAV may be less than the defined floor in certain circumstances especially if market opens with gap between two trading sessions or liquidity of the underlying dries up.
The upside participation will be less than 100% The upside participation in equity may be less than 100% due to cushion maintenance for downside protection. Higher the floor, normally lower the participation.
The NAV may not rebound with market in same proportion after a severe correction. After severe correction the portfolio goes into cash to preserve NAV at the defined floor level. This would result into extra cushion not being available for additional equity investment and hence there will be negligible upside participation.
If the floor is hit, the portfolio will become 100% Cash.
The chart demonstrates how the model reduces equity exposure when the market goes up and increases equity exposure when the market comes down.
Nifty STraP, due to its dynamic nature can serve as an ideal tool for tactical asset allocation.
|Max. Returns||There is no cap on maximum returns.|
|Min. Investment||Rs. 25 Lakhs & in multiples of Re. 1/- thereafter|
|Fees||2.5% per annum plus applicable service tax (Fees will be charged quarterly in arrears)|
|Exit Load||Before 1 Year - Balance Annual Fees, After 1 Year — Nil|
|Daily||NAV and holdings on request|
|Annual||Audited annual report for the account|