Guest Post: Equity Duration Immunization And Mismatch
Submitted by Yves Lamoureux of Blackmont Capital
Since 2007, participants making tactical asset allocation bets resulted in disasters. For most funds the focus was lopsided. If this strategy did not work in 2008, why do they think it will work in 2010?
We are very critical of risk management these days. It would seem to us that bets are again over-concentrated.Risk premiums have seen large decline and it is if nothing ever happened.
Tactical asset allocation should give some exposure to unexpected shifts in interest rates.The problem owes itself to a duration mismatch in asset classes held today.
Equity duration is similar to bond duration. It measures the sensitivity of equities to interest rates. The research on this subject is fascinating. Each year Standard & Poor publishes a report with the duration for the S&P 500. They estimate the duration of the S&P 500 index to be 34 years at the middle of 2009. The index is very high in view of the history of the data.
The model uses the dividend discount model and the sensitivity of growth to rates is included.
Duration is higher for high growth stocks and stocks in a low discount rate environment.
If stocks are now reflecting long durations and if I am correct, funds own short duration bonds
Is there not a perfect mismatch ?
In trying to match assets with liabilities in a way that is immune to interest rates movement one will talk of immunization. Actual position in many funds today would show poor immunization. The tactical bets seemed one sided and geared to higher rates and inflation.
The question to ask is why so many funds would accept to leave such a big gaping hole in risk management today. Just like a goalie who would cover only one side of the net and leave the other half wide open for the opponent to score in…..
Yves Lamoureux, Investment Advisor, Blackmont Capital Inc
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Thanks to Srikant Dash for allowing us use of the graph of Standard & Poor’s