The Duration Connection
Executive Summary
Over the last six or seven years, most financial assets have done very well. The performance divide has not been between low-risk assets and high-risk assets or between liquid assets and illiquid assets, but between long-duration assets and short-duration assets. Long-duration assets such as stocks, bonds, real estate, and private equity have benefitted from a large fall in the discount rate associated with their cash flows, while short-duration assets have been hurt by the same fall. Investors tend to tilt their portfolios in favor of those assets that have done well, and today that pushes them to be increasing effective duration in their portfolios, just when the potential returns to those assets have dropped. What we believe would be most helpful to investors are short-duration risk assets, as they offer the potential of decent returns over time with less vulnerability to rising discount rates. These assets, generally lumped together under the “alternatives” title, are generally out of favor today given their disappointing performance since the financial crisis, but the characteristics that made them disappoint may well prove a blessing if discount rates start to rise.
Introduction
In most of the economic ways that count, the years following the financial crisis have been somewhere between disappointing and unspeakably bad. Economic growth in the developed world has been slower than at any comparable period barring the Great Depression. Productivity growth has been the worst since the invention of GDP,1 and corporate investment has remained stubbornly low. According to a McKinsey Global Institute report, two-thirds of households in the developed world had incomes as of 2014 that were flat or fell relative to 2005 (81% of households for the US in particular).2
After a burst of growth in the emerging world associated with China’s enormous stimulus policy of 2008-10, growth has also come to a crawl in the emerging economies, laying bare corruption and structural problems that appeared to be minor when times were better. But in one way, the last seven years have been a glorious success. Performance of most financial assets has been very strong, with assets from US equities to global real estate and infrastructure to credit and government bonds all giving strong returns. Even the laggards – non-US developed and emerging equities – have been disappointing on a relative, though not really an absolute basis. It isn’t all that often that everything does well at the same time. We have been conditioned to think of stocks and bonds as complements to each other, with one doing well when the other does poorly. In this cycle, we’ve gotten an almost magical benefit, where on a daily basis the correlations have been negative, but over the full seven years both assets have gone up strongly, along with most other assets. Apart rom emerging equities, the only assets that have really disappointed seem to be commodities, cash, hedge funds, and other hedge-fund-like alternative assets and strategies. We believe there is a common factor that explains much of this. We believe further that it is important to realize that the strong returns to the assets that have done well over the last seven years are at best a one-off benefit and, more plausibly, will have to be given back over time. To us, this suggests that while alternatives have been a drag on institutional portfolios over the last six or seven years and privates (real estate, private equity, venture capital) have been a boost, in coming years the reverse may well be true.3 rom emerging equities, the only assets that have really disappointed seem to be commodities, cash, hedge funds, and other hedge-fund-like alternative assets and strategies. We believe there is a common factor that explains much of this. We believe further that it is important to realize that the strong returns to the assets that have done well over the last seven years are at best a one-off benefit and, more plausibly, will have to be given back over time. To us, this suggests that while alternatives have been a drag on institutional portfolios over the last six or seven years and privates (real estate, private equity, venture capital) have been a boost, in coming years the reverse may well be true. 3
The duration effect
The common factor that explains much of the return pattern we have seen in recent years is duration. The assets that have done well do not necessarily share that much in common, but they do all share a structure that they embody at least somewhat predictable cash flows that will occur over an extended period of time. The value of those cash flows changes materially if the discount rate applied to those cash flows changes. We are used to talking about the duration of fixed income instruments, but not necessarily for assets like equities, real estate, LBOs, etc. But all of these assets can readily be valued through a discounted cash flow process, and the sensitivity of the present value to a change in the discount rate is precisely analogous to the duration of a fixed income security . And what has happened to those discount rates is pretty uniform across asset classes.4
Table 1 shows an estimate of the change in the discount rate from a 2009-10 average to year end 20155 along with an estimate of the effective duration of the asset class with regard to that change....
1 This is a little less impressive than it sounds, given that GDP wasn’t created until the middle 1940s, but nevertheless....MUCH MORE
2 “Poorer than their parents? A new perspective on income inequality,” McKinsey Global Institute, July 2016.
3 Venture capital might be an exception to this. As Jeremy Grantham has written, venture capital has some unique characteristics that may well accrue to its benefit in this cycle. It is the hardest asset class to make any sweeping generalizations about entrance valuations; it can be a significant beneficiary of the high return on corporate capital that currently exists in the US; and, as the most volatile asset around, is probably least plausibly affected by a change in the yields to low-risk assets. Even with these characteristics, assuming it could continue its fairly torrid returns of the last cycle seems like a real stretch.
4 I have to admit that part of the reason for the apparent uniformity is that for asset classes for which I couldn’t really estimate a discount rate (private equity, venture, commodities, alternatives) I used 1.5%, which is the same as the US 30-year Treasury and the S&P 500.
HT: I think it was Reformed Broker but don't recall when.
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