could someone please explain the following: If cash drag is a concern, why would an investor prefer a CPPI approach over a Buy and Hold in a declining market and objective is to protect using a floor. I guess I’m confused because both provide a floor if Stocks reduce to zero. Why isnt there a cash drag for CPPI?
Since M>1 for CPPI and M=1 for Buy and Hold [Eq=m(TA-F)]; the CPPI will sell of your equity exposure faster than the buy and hold in a declining market. You can also see this when you consider that the CPPI graph is convex while the B&H is linear.
McLeod - yes i understand that…ok maybe i dont understand what cash drag is. ok…just as its worded…cash drag is the lag time before a position is converted to cash?
Cash drag is a problem over the long-run under the assumption that long-run portfolio returns will be positive. Cash is only a drag on performance if returns on the rest of your portfolio are rising. If the portfolio is decreasing in value, then the higher allocation to cash will actually increase your portfolio (or decelerate its decline in value). With CPPI, since M>1 cash positions will be reduced faster once the market rebounds vs. a buy and hold strategy. So with CPPI you are going to cash faster in a dropping market and getting out of cash faster in a rising market. This is why CPPI performs best in trending markets.
Mcleod - ok makes complete sense. thanks for clarifying
Cash drag is just the fact that cash has a lower return in up markets right? So anything in cash isn’t earning what the rest of the portfolio is. Is there an alternate definition in this reading?
I think “cash drag” specifically, is referring to the negative effect of cash that is only present in rising markets.
yeah, cash wasn’t a drag last year.
It could have been if you were short. : ) Which brings up a question. Is there only drag in rising markets or is there drag when the allocation of the fund is outperforming the cash? Like if you were short in 2008. I think of cash drag as the amount of cash necessary to fund operation of the mutual fund or whatever than can’t be invested in the mandate of the fund (say equities).
From what I understand: (1)In a flat oscillating market, a CPPI will do relatively poorly, as the investor buys on strength only to the see the market weaken, and sells on weakness only to see the market rebound. (2) In a trending bull market (without too many reversals), the CPPI strategy will do very well as the investor is buying more shares as they rise. In technical jargon, the payoff is convex which increases at an increasing rate. (3)The portfolio will do at least as well as the floor, even in a severe bear market. Such a strategy puts more and more into cash as the share market declines, reducing the exposure to shares to zero as the portfolio approaches the floor. (4)The only scenario in which the portfolio might do worse than the floor is if the market drops precipitously before the investor has had the chance to rebalance.