Archive for October, 2008

Portfolio Stress Testing

Portfolio stress testing is a means of identifying unusual circumstances that could lead to larger than expected losses. It frequently takes the form of scenario analysis or a simulation of historical or hypothetical events.

In a scenario analysis, stylized scenarios ranging from modest to extreme outcomes are modeled individually. For example, scenarios could include a 10-basis point interest rate move in either direction, a 100-basis point move in either direction, and a steepening or flattening of the yield curve. By using standard measures such as these, scenario analysis can facilitate risk comparisons across assets. However, it does not account for correlations between risk exposures – for example, the effect of both a 100-basis point move in interest rates and a steepening yield curve would not be known.

Simulation of hypothetical or actual historical events is used to see how the entire portfolio would perform when subjected to a given set of extreme conditions. It is particularly useful when extreme breaks (price gaps) are considered more likely that the model being used assumes.

Posted on 29th October 2008
Under: Governance, Portfolio Management, Risk Management | No Comments »

Investing in Distressed Securities

Investors seeking exposure to securities issued by companies in distress are typically seeking higher returns in exchange for the added risks. Success in distressed security investment requires unique skills, and typically investors participate via vehicles such as hedge funds or private equity funds. Hedge funds offer greater liquidity for the investor (and greater access to capital for the manager.) However, the illiquid nature of many distressed securities may confer advantages to the fixed term and closed-end structure of private equity funds.

There are a number of security types that relate to distressed companies:

  • The publicly traded debt and equity
  • Newly issued (orphan) equity of companies recently emerged from reorganization
  • Bank debt and trade claims that the original creditor may wish to monetize
  • “Lender of last resort” notes

Frequently investors use these securities in conjunction with a range of derivative products to hedge related risks.

The reasons distressed securities can offer high risk-adjusted returns relates to the market opportunity that arises because other investors are either unwilling or unable to participate in the market. Some funds are prohibited from owning speculative grade debt, and are forced to sell holdings that lose an investment grade rating regardless of price. Others do not wish to participate in drawn-out bankruptcy proceedings and will accept a fraction of the value of their claims in exchange for immediate cash. In other cases, failed leveraged buyouts or unduly shunned companies that recently emerged from bankruptcy may create a temporary imbalance of supply and demand for their securities.

Posted on 28th October 2008
Under: Active Management, Alternative Assets, Investing in Distressed Securities, Investment Returns, Portfolio Management, Risk Management | No Comments »

The Role of Private Equity Investments in a Portfolio

Private equity investments typically have a low correlation to the returns on stocks and bonds, which provides a diversification benefit. Investors should understand, however, that the use of appraisals can result in a stale valuation and could partially explain the low correlation. If annual returns are used for both private equity and traditional assets, the correlations appear higher.

Although the risk reduction benefits may be modest, the expertise required to invest in private equity usually results in a higher return on investments. Therefore, a modest inclusion in the portfolio may still be merited.

Posted on 27th October 2008
Under: Alternative Assets, Asset Allocation, Institutional Investing, Investing in Private Equity, Investment Returns, Portfolio Management | No Comments »

Endogenous Growth Theory

Growth theory seeks to explain the rate of GDP growth in different countries.

Endogenous growth theory assumes that marginal productivity of capital does not necessarily decline as capital is added. Instead, technological advances and improved labor force education can increase productivity and lead to efficiency gains. As such, the economy may never reach a steady state.

Posted on 25th October 2008
Under: Economic Analysis, Fixed income investments | No Comments »

Endogenous Growth Theory

Growth theory seeks to explain the rate of GDP growth in different countries.

Endogenous growth theory assumes that marginal productivity of capital does not necessarily decline as capital is added. Instead, technological advances and improved labor force education can increase productivity and lead to efficiency gains. As such, the economy may never reach a steady state.

Posted on 25th October 2008
Under: Economic Analysis | No Comments »

Investing in Emerging Market Debt


  • Low correlation to developed markets is good for diversification
  • Have proven resilient to financial crises and are earning investment grade ratings in many cases
  • Sovereign emerging market debt in particular can:
    • respond to negative events by raising taxes and reducing spending
    • have access to lenders such as IMF and the World Bank
    • have large foreign currency reserves as a cushion


  • High volatility
  • Negative skewness of returns
  • Lack of transparency
  • Lack of legal and regulatory structure
  • Sovereign borrowers tend to over-borrow and there can be little recourse for foreign lenders in the event of default

Posted on 24th October 2008
Under: FInancial Planning, Fixed income investments, International Investing, Investing in bonds, Portfolio Management | No Comments »

Tools for Setting Capital Market Expectations

When estimating the risk and return characteristics of various asset classes, there are a number of tools available to analysts.

  1. Statistical methods can be descriptive (classify past results) or inferential (used for predicting results.)
    • Sample estimators estimate the future mean and variance based on the sample’s past mean and variance.
    • Shrinkage estimators rely on judgment to weight historical estimates with other parameters in order to reduce the impact of extreme values
    • Time series estimators forecast a variable based on the lagged values of either the variable itself or other variables
    • Multi-factor models explain returns for an asset in terms of the values of a set of return drivers or risk factors
  2. Discounted cash flow models express current value in terms of the future cash flows an asset will generate
  3. The risk premium approach expresses expected return as the risk free rate plus a risk premium that reflects the uncertainty surrounding future results
  4. Financial market equilibrium models describe relationships between expected return and risk in which supply and demand are in balance

Posted on 18th October 2008
Under: Asset Allocation, FInancial Planning, Investment Returns, Portfolio Management | No Comments »

Market Structure Indicators

Market structure indicators are the primary tool of technical analysis. They monitor the trends of various price indexes, market breadth, volume, etc. Technical analysts use them to monitor the health of the prevailing trend.

Market structure indicators include moving averages, patterns, trendlines and peak/trough analysis. Most of the time, the trends for various indicators move together. When the different indicators diverge, or offer different signals, it is often a sign that a trend reversal will take place.

Posted on 10th October 2008
Under: Technical Analysis | No Comments »

High Yield Bond Returns: Downgrades versus Original Issues

Bonds may either be issued as speculative grade bonds (original issue)or become so following a rating downgrade (fallen angels). In either case, their risk-adjusted returns should be similar. However, in an article published in the Fall 2007Journal of Portfolio Management Fridson and Sterling point out that fallen angels have historically delivered far higher risk-adjusted returns, and discuss several explanations for an apparent market inefficiency.

The authors find the correlation between fallen angels and original-issue speculative grade debt to be lower than that between Treasuries and investment-grade corporate bonds, suggesting dissimilar attributes and below the threshold normally used to classify securities as part of the same asset class.

Possible reasons for the disparity include:

  • Lack of investor awareness, given that the primary high-yield index only recently began breaking out the performance of the two categories
  • Emphasis on security selection and possible overconfidence among managers that they can pick the superior original-issue bonds
  • Investability – fallen angels account for just 30% of available speculative-grade debt and trade infrequently
  • Lottery-like returns for specific original issue bonds
  • Yield appeal due to higher yields typically found with original issue bonds

Posted on 6th October 2008
Under: Active Management, Investing in Distressed Securities, Investing in bonds, Investment Returns, Performance Measurement, Research, Risk Management | No Comments »

Custom Factor Attribution

Many portfolio analysts use different sets of variables for portfolio return and risk attribution, respectively. As risk and return tend to be intimately linked, this practice can obscure the relationship between the two. In the March/April 2008 Financial Analysts Journal Menchero and Poduri demonstrate how to align return attribution and risk attribution into a general framework.

Active return, tracking error and the information ratio are attributed to a user-defined set of factors reflective of the manager’s decision-making process. The attribution can be applied on either an ex ante or an ex post basis.

Posted on 5th October 2008
Under: Uncategorized | No Comments »