Equity Duration, an oxymoron or an important portfolio exposure?

Duration, which is a highly common metric amongst the fixed income community, measures the sensitivity of a portfolio to movements in interest rates.

12 Jul 2019

Within the equities community, duration is somewhat of a foreign concept. However, Zenith believes it is highly important.

In its purest form, duration measures the length of time required for cashflows from an asset to fully repay the initial investment. In the case of equities, Zenith measures duration through dividend yields. For example, if the stock has a dividend yield of 5% p.a., it would take 20 years for dividends to fully repay an investor’s capital, representing a duration of 20.

What is long duration? What is short duration?

Long duration equities are those that are expected to deliver a higher proportion of future cashflows in the distant future. In contrast, short duration equities are expected to deliver a higher proportion of cashflows in the near future.

Long duration equities are more sensitive to interest rate movements relative to short duration equities. Put another way, if interest rates decline, share prices of long duration equities should rise more than those of short duration equities.

Value versus Growth

The chart below contrasts the average durations of ASX-listed growth stocks and value stocks, as represented by the MSCI Australia Growth and MSCI Australia Value Indices over the five-year period to 31 March 2019.

As evident in the chart above, growth stocks are longer duration than value stocks and have therefore benefitted more from falling interest rates.

Large Cap versus Small Cap

Splitting the universe into large caps and small caps can yield a similar interpretation. The chart below compares the duration of large caps as represented by the S&P/ASX 20 Index against small caps as represented by the S&P/ASX Small Ordinaries Index.

Large caps are typically more mature businesses that generate higher cashflows and, in turn, higher dividends, relative to small caps. In contrast, small caps are generally in the growth stage of their business cycles and require high levels of capital reinvestment, resulting in lower dividend yields.

Sector Durations

The duration of the underlying segments of the Australian equities market can vary significantly. We have highlighted the sectors that we identified to be at opposite ends of the duration spectrum in the chart below.

Sectors with higher dividend yields, such as Telecoms, Financials, Utilities and Property are short duration. While high growth sectors, with lower dividend yields, such as Healthcare and Tech, are long duration.

What is the duration of Zenith’s rated Australian equities funds?

We have calculated the durations of our rated funds, grouping them in the following investment styles – Income, Value, Neutral and Growth. The chart below shows the durations of our rated funds.

As per our expectations, funds investing in companies paying the highest dividends are the ones with the shortest duration. As such, income funds were found to have the shortest duration. Conversely, growth funds exhibited relatively longer duration.

It is important to note that each investment style has at least one outlier. As such, Zenith believes it is important to fully understand the characteristics of funds rather than purely focusing on investment style classifications.

Putting this all together

Zenith believes the following quote from a successful hedge fund manager rings true:

“A fiduciary should think more about the safety of an entire portfolio than about any individual holding” – Seth Klarman

With the need to assess portfolios holistically, we believe equity duration should be considered alongside fixed income duration. Zenith believes that investors should not be overly concerned if their fixed income exposure is underweight duration, as this can be offset by a tilt to small caps or a growth fund within the equities component of an investor’s multi-asset portfolio.

Ultimately, Zenith believes the consideration of equity duration as part of a diversified multi-asset portfolio will help investors achieve a more balanced investment outcome.

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