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Recent Research: Highlights from February 2013

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"Volatility, Correlation, and Diversification in a Multi-Factor World"
The Journal of Portfolio Management (Winter 2013)
Richard Roll

In a multi-factor world, diversification benefits do not generally depend on correlation. Investors can restructure portfolios to align factor sensitivities. This implies that diversification benefits depend only on the idiosyncratic volatility that remains after restructuring. Similarly, the risk reduction that follows adding an asset to an existing portfolio does not depend on the asset’s correlation with the portfolio. These implications evince the fundamental importance of measuring the underlying factors and estimating factor sensitivities for every asset. Other researchers have investigated several methods for measuring factors. An easy-to-implement general method involves specifying a group of heterogeneous indexes or traded portfolios. Exchange-traded funds (ETFs) could be well suited to this purpose.

"US Structured Finance Markets: Recent Recovery, Post-Crisis Developments, and Ongoing Regulatory Uncertainties"
The Journal of Structured Finance (Winter 2013)
Christopher L. Culp and J. Paul Forrester

In this article, the authors review the recent activity in US structured finance markets and offer some comments on the changes in certain structured finance products resulting from the global credit crisis. They believe that these changes have helped foster an environment consistent with the return of economically legitimate uses of fundamentally sound structured financing techniques. The authors discuss specific changes in the market for collateralized loan obligations (CLOs) as an illustrative example. They also discuss the potential impact of various ongoing regulatory initiatives that may affect (perhaps significantly) the near- and long-term prospects for U.S. structured finance products and markets. The data currently indicate renewed investor interest in many of these products, and in the authors’ view, the post-crisis changes in the design and documentation of these products together with heightened investor awareness and better access to information suggest that such interest is not merely irrational yield-chasing. Yet, the ongoing regulatory uncertainty poses significant potential threat to the future of the US structured finance market. Many of the possible dangers arising from pending or proposed regulations seem, moreover, to be unintended consequences of rules that were not specifically aimed at structured finance (e.g., the Volcker Rule). Unless regulators address those unintended consequences (and perhaps some intended ones), the prospects for the return of a vibrant and well-functioning structured finance market to facilitate legitimate risk transfer and asset funding may be much dimmer than recent market experiences otherwise suggest.

"Recognizing Investor 'Comfort' Assets in Portfolio Optimization"
The Journal of Wealth Management (Spring 2013)
Steven Dym

The author observes that not all asset decisions fit neatly into the traditional risk–return paradigm of portfolio selection. For example, investors may wish to include in their portfolios a minimum percentage representation, or an absolute dollar amount, of socially conscious firms. A simple solution involves specifying a minimum amount of the asset and applying nonlinear optimization techniques to the entire portfolio. This strategy, however, does not recognize the special nature of the investor’s preference and how it expresses itself in the portfolio. The author presents an alternative technique, illustrated through the use of gold as a comfort asset, as applied to a portfolio of foreign currency–denominated securities. There, the investor chooses the optimal asset allocation (including currency hedging), recognizing gold as both a currency diversifier and “desired asset,” independent of its expected return, risk, and correlation with other assets.

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