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.
TOPICS: Credit risk management, CLOs, CDOs, and other structured credit, portfolio construction
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