Risk and Valuation Issues
THE PORTFOLIO DIVERSIFICATION MYTH
The least useful finance nursery rhyme for CDO investors is “Diversification reduces risk.” Diversification is often an illusion, and diversifying simply for the sake of it can add risk to an investor’s portfolio or lull an investor into a false sense of prudence so that the investor ignores discrete risks in the portfolio.
Unskilled investors often diversify for the sake of diversification, and CDOs can “help” them diversify into their areas of incompetence. Diversification doesn’t guarantee you won’t lose money; it only guarantees that it is unlikely you will lose it all at once. Diversification is a defensive strategy, and like all defensive strategies, it is most effective if you know what you are defending against.
There is no point in diversifying just for the sake of it; only diversify into assets you understand well. The best investment managers diversify into businesses they understand, businesses that throw off tremendous cash flows, and businesses that have high growth potential. At least, they do that most of the time. Highly skilled investors often diversify less and perform better than less skilled managers.
Lack of due diligence on the collateral in portfolios, CDO cash flow structures, and the background of the CDO manager have been the key reasons that investment-grade CDOs have performed poorly. This chapter primarily deals with the first of those issues.
While investors need to consider ...