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

The opinions contained in this report are those of the author and are not necessarily those of Blackmont Capital Inc.. Every effort has been made to ensure that the contents of this document have been compiled or derived from sources believed to be reliable and contains information and opinions which are accurate and complete. However, neither the author nor BCI makes any representation or warranty, expressed or implied, in respect thereof, or takes any responsibility for any errors or omissions which may be contained herein or accepts any liability whatsoever for any loss arising from any use of or reliance on this report or its contents. BCI is an independently owned subsidiary of CIFinancial. CI Financial is a Canadian owned diversified wealth management firm, publicly traded on the TSX under the symbol CIX. Blackmont Capital Inc. is a member of CIPF and IIROC.

Thanks to Srikant Dash for allowing us use of the graph of Standard & Poor’s


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