Saturday, December 22, 2007

The theory and implications of expanding traditional portfolios

The theory and implications of expanding traditional portfolios

Vanguard Investment Counseling & Research, 12/20/2007

Executive summary. Traditionally, investors have focused on portfolios consisting of the three primary asset classes—stocks, bonds, and cash. More recently, many investors have been considering expanding their traditional portfolios, as a result of three forces: the 2000–2002 bear market in equities, the widely held view that traditional assets will produce lower returns in the near future, and a growing push to diversify across asset classes and strategies. Many financial models often recommend allocations to non-traditional asset classes and strategies that have a low historical correlation to stocks, bonds, and cash. However, when exploring the implications of expanding a traditional portfolio, investors often overlook the challenges of implementing the recommended changes. We discuss why an investor may consider expanding a traditional portfolio, and we show that including non-traditional asset classes and strategies can work. We also discuss implementation risks for non-traditional asset classes and strategies, and offer some best practices for investors.

Thursday, December 20, 2007

Middle East and North Africa Markets: Investment Challenges and Market Structure

Middle East and North Africa Markets: Investment Challenges and Market Structure

Zaher, Tarek S., (November 1, 2007). Networks Financial Institute Working Paper No. 2007-WP-30


This paper highlights the major developments and structural changes in the Middle East and North Africa (MENA) markets. Noticeable growth was observed in these markets during the last decade. This is evidenced from the record growth rates in market capitalization, number of listed companies, value traded and shares traded in most of the MENA capital markets. Stock market boom was also observed, by the end of 2005, in many of the MENA countries. This was followed by a major correction (crash) in these MENA countries. To support the growth in capital markets and attract more local and foreign investors, MENA markets would need continue to incorporate changes to procedures, laws and the professional infrastructure within the financial market and better dissemination of information. Compliance with international and regional laws is also essential for a healthy development.

The paper also examines the evidence underlying the notion that there is increased integration of MENA and developed country financial markets and that MENA market equities do not represent a separate asset class. We analyze the correlation structures among individual country equity markets and efficient frontiers over two sub periods. We also analyze the structure of the correlations among political risk indicators for a similar group of countries over similar time periods. The results of the study suggest that capital market integration has accelerated in recent years, both economically and politically, but only for three countries in the MENA region. We therefore conclude that the MENA market countries should continue to be viewed as separate asset class from developed countries. These markets seem to be highly segmented and provide great diversification potentials to global investors.

Thursday, December 13, 2007

International Stock Market Correlations: A Sectoral Approach

International Stock Market Correlations: A Sectoral Approach

Fasnacht, Philipp and Louberge, Henri, (December 2007). Paris December 2007 Finance International Meeting AFFI-EUROFIDA

A lot of studies dealing with international correlations look only at correlations at the market level and often use its time-varying nature as motivation for their work. However, why and how market correlations change is a point that is still not very well understood. As the market is composed of different sectors, we propose to look into this question by studying the behavior of equity correlations at the sectoral level. We show how sectoral correlation coefficients determine the market correlation coefficient and decompose the latter into two parts; one that represents country factors and one that represents industry factors. This decomposition allows us to get a clear idea on how and why market correlations change over time. We also get some interesting insights such as market level correlations are higher on average than sectoral correlations as well as that sectoral correlations between countries tend to do be more stable over time than market level correlations and sectoral correlations within countries. Finally, we present evidence that a few sector correlations related to Financial, Industrial and Consumer Services segments drive the evolution of the market level correlation.

Wednesday, December 12, 2007

Mortgage Backed Securities

Solving The Mortgage Mystery by Barclays Global Investors, Investment Insights, 11.05

Mortgage-backed securities represent a major segment of the investment-grade fixed income universe in the United States and, therefore, a considerable portion of most investors’ fixed income portfolios. Despite their significant role in institutional portfolios, the complexities of mortgages have made it difficult for many investors to fully understand the idiosyncrasies associated with this asset class.
This paper sets out to help investors gain a better understanding of mortgages so they can effectively manage value and risk within the asset class and separate beta risk from alpha opportunities.

Analysis of Mortgage Backed Securities by Stein, Harvey J., Belikoff, Alexander L., Levin, Kirill and Tian, Xusheng, (January 5, 2007).

Valuation of mortgage backed securities (MBSs) and collateralized mortgage obligations (CMOs) is the big science of the financial world. There are many moving parts, each one drawing on expertise in a different field. Prepayment modeling draws on statistical modeling of economic behavior. Data selection draws on risk analysis. Interest rate modeling draws on classic arbitrage pricing theory applied to the fixed income market. Index projection draws on statistical analysis. Making the Monte Carlo analysis tractable requires working with numerical methods and investigation of a variety of variance reduction techniques. Tractability also requires parallelization, which draws on computer science in building computation clusters and analysis and optimization of parallel algorithms.

Here we detail the different components, describing the approach we have taken at Bloomberg in each area. Our particular emphasis is on the new interest rate modeling component we introduced for computing OAS, and the methods used to calibrate it accurately. We discuss the methods used to enable real time analysis of CMOs, analyzing the impact of various Monte Carlo variance reduction techniques as well as the technology used for parallelization of the computations. We also detail the validation of these components, showing that everything works well together, and yields good MBS and CMO valuation.

How Resilient are Mortgage Backed Securities to Collateralized Debt Obligation Market Disruptions? by Mason, Joseph R. and Rosner, Josh, (February 13, 2007)

The mortgage-backed securities (MBS) market has experienced significant changes over the past couple of years. Non-agency ("private label") securities, which are not guaranteed by the government or the government sponsored enterprises, now account for the majority of MBS issued. In this report, we review the rise of collateralized debt obligations (CDOs), the relaxation of lending standards, and the implementation of loan mitigation practices. We analyze whether these structural changes have created an environment of understated risk to investors of MBS. We also measure the efficacy of ratings agencies when it comes to assessing market risk rather than credit risk. Our findings imply that even investment grade rated CDOs will experience significant losses if home prices depreciate. We conclude by providing several policy implications of our findings.

Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions by Mason, Joseph R. and Rosner, Josh, (May 3, 2007)

Many of the current difficulties in residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs) can be attributed to a misapplication of agency ratings. Changes in mortgage origination and servicing make it difficult to evaluate the risk of RMBS and CDOs. We show that the big three ratings agencies are often confronted with an array of conflicting incentives, which can affect choices in subjective measurements of risk. Of even greater concern, however, is the fact that the process of creating RMBS and CDOs requires the ratings agencies to arguably become part of the underwriting team, leading to legal risks and even more conflicts. We analyze the fundamental differences between rating structured finance products like RMBS and CDOs and traditional products like corporate debt. We show that the inefficiencies of rating RMBS and CDOs are leading investors to discount U.S. markets. We conclude by providing several policy implications of our findings.

Monday, December 03, 2007

Dynamic Allocation Strategies for Distribution Portfolios: Determining the Optimal Distribution Glide Path

Dynamic Allocation Strategies for Distribution Portfolios: Determining the Optimal Distribution Glide Path
by David M. Blanchett, CFP®, CLU, AIFA®, QPA, CFA (JFP, December 2007)

Executive Summary

  • The purpose of this paper is to determine the optimal allocation strategy (referred to as the distribution glide path) for a portfolio subject to withdrawals. But unlike most previous research, which uses static allocations, the paper includes a dynamic allocation methodology. It also introduces a methodology to incorporate risk into the decision process.
  • Using historical data from four asset categories from 1927 to 2006, 43 different distribution glide paths were considered for 21 different time periods and 51 different real withdrawal rates.
  • Despite the expected benefits of more sophisticated dynamic distribution allocation strategies, static equity allocations proved to be remarkably efficient.
  • The most optimal glide path from a pure probability-of-success perspective was the 100/0 (100 percent equity and 0 percent fixed income/cash) static allocation portfolio. But due to the underlying variability of a 100/0 portfolio, it is unlikely that this allocation will be appropriate for most retirees.
  • The absolute differences in the probability of failure among glide paths for shorter distribution periods and lower real withdrawal rates (less aggressive scenarios) were minor. The absolute differences for longer distribution periods and higher real withdrawal rates (more aggressive scenarios) were considerable.
  • The paper introduces a risk-adjusted measure called the Success to Variability ratio in order to incorporate portfolio variability (standard deviation) into the optimal glide path decision process.
  • When considering a variety of distribution periods and real withdrawal rates, as well as the probability of failure and the Success to Variability ratio, a balanced static allocation, such as 60 percent equity and 40 percent fixed income/cash, is likely one of the most efficient portfolio allocations for retirees.