Equity duration: An oxymoron or an important portfolio exposure?

From

Quan Nguyen

Duration, despite being a common measure within the fixed income community, is a relatively foreign concept when it comes to equities. However, the latest research from Zenith Investment Partners shows that considering equity duration can be a powerful tool in constructing investment portfolios.

Duration is the length of time required for cashflows from an asset to fully repay the initial investment, explains Quan Nguyen, Head of Equities at Zenith.

“In the case of equities, we measure duration through dividend yields. For example, if a stock has a dividend yield of 5% p.a. it would take 20 years for its dividends to fully repay an investor’s capital. This represents a duration of 20 years.”

Long duration equities are expected to deliver a higher proportion of future cashflows in the distant future, while short duration equities are expected to deliver a higher proportion of cashflows in the near future. The other important characteristic to note is that long duration equities are more sensitive to interest rate movements and as a result have benefited more from the recent decline in Australian interest rates.

“At Zenith, we believe it is important to assess portfolios holistically. This means considering equity duration alongside fixed income duration,” said Nguyen.

To help advisers better understand equity duration, Zenith, in its 2019 Australian Shares – Large Companies Sector Report, looks at the duration of stocks within the Australian equity market.

“Our research found that for the 5 years to 31 March 2019, growth styled funds exhibited longer duration than value styled funds and have therefore benefited more from falling interest rates,” explains Nguyen.

“If we split the universe into large caps and small caps, it yields a similar interpretation. Large caps are typically shorter duration relative to small caps.”

Understanding equity duration means that investors do not need to be overly concerned if their fixed income duration is underweight, as this can be offset by a tilt to small caps or a growth fund within the equities component of their multi-asset portfolio.

Ultimately, Nguyen believes that the consideration of equity duration will help investors achieve a more balanced investment outcome.

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