CDO Equity

Abstract

Individual CDO equity deals typically have large annual returns, but also can exhibit high return volatility. Using historical cash returns, the authors demonstrate that investors can improve risk-adjusted returns from CDO equity by diversifying into multiple deals, both within and among collateral classes and vintages. A portfolio constructed with even a modest number of CDO equity deals substantially lowers cash return uncertainty over that for a single deal. A 20-deal portfolio decreases the inter-quartile return range by 80%. The marginal impact of CDO equity diversification diminishes rapidly beyond 20 issues in a portfolio. A CDO equity fund-of-funds structure provides an efficient means of accessing a diversified portfolio of CDO equity.