Why understanding duration is essential for effective risk management!

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Key Points

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• Equity markets have become increasingly concentrated, primarily in one sector: technology.

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• This has altered the equity market's risk characteristics. Its duration has increased, making it more sensitive to changes in inflation/interest rates.

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• Be aware of these changes and the potential impacts on your portfolio settings and respond if the evolving characteristics do not align with your objectives.

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• This can be achieved within the asset class by reducing duration exposure – one potential method is to increase exposure to lower duration factors, such as Value.

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• Further diversification can also be effectively achieved at the portfolio level by adding alternative exposures; however, these would ideally include exposures with lower duration or interest rate sensitivity, where appropriate to the investor’s objective.

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• Lastly, why does this matter today? Since Trump’s inauguration, we’ve faced an increasingly uncertain geopolitical environment that’s driving changes in sentiment. This, in turn, is influencing inflation and interest rate expectations, which are becoming more volatile.

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In Part 1, I discussed some risks I see beginning to emerge in portfolios. In this article, I will connect these points and share some thoughts on mitigating these risks.

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An outline of the original risks discussed in Part 1 are below:

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1) The increasingly concentrated index construct has been driven by the growing dominance of the technology sector and the valuations assigned to it. This development is specifically attributed to the major US technology companies, which have become a significant part of the global equity index.

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2) The technology sector's growth characteristics are long-duration in nature. Thus, as the sector’s dominance has grown within the market, the market has also become longer in duration. Thus, the market risk premium has become more sensitive to inflation and interest rate shocks.

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3) A heightened sensitivity to inflation and interest rate shocks, in the context of a more volatile global geopolitical landscape, increases the likelihood of both a greater number of shocks and the potential for more substantial market drawdowns.

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Identifying these risks in the current market environment is something investors should be aware of and mitigate if necessary, according to their objectives and circumstances.

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I will recap these risks and provide more context for my increasing worry. Then, I will investigate potential methods to temper these risks, including mitigants at the asset class level and across a multi-asset-class portfolio.

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Is Concentration a Risk?

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Investing in a concentrated manner is not uncommon, nor is it seen as an inappropriate method for managing a portfolio. In fact, many successful investors intentionally target portfolios with limited instruments. Managers who employ this strategy typically share a common trait: they have a deep understanding of their investments. Warren Buffett and his Berkshire Hathaway are perhaps the most well-known examples, with the top 10 investments constituting roughly 90% of the portfolio. Why does a concentrated portfolio work for Warren Buffett? I would suggest that his portfolio is skilfully constructed, founded on solid research that allows for reliable forecasts of expected returns while ensuring strong risk management. This approach results in a relatively low degree of correlation, or high diversification, among its top 10 holdings, even though the portfolio is very concentrated. This contrasts with the current Index structure, where the largest Index weights are heavily skewed towards a single sector.

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The issue with such a strategy (as with all investment strategies) is not when you get it right but when you get it wrong.

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Let’s now apply this thinking to the Index.

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Due to the lower levels of diversification, the volatility characteristics of the index have begun to align more closely with the most prominent positions in the index. This leads to the index increasingly behaving like those stocks. The largest stocks in the US and, therefore, the global equity index are currently high-growth (longer duration) tech stocks. It is also crucial for this discussion to note the dominance of a single sector, unlike the Berkshire Hathaway portfolio. Tech tends to be considered a longer duration than the other sectors, and thus more sensitive to interest rate changes, as they are expected to generate a larger portion of their cash flows in the distant future, making their valuations more sensitive to changes in discount rates. Several studies have provided a link between growth stocks and duration.

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It is also important to note that it appears investors aren’t selecting these prominent stock positions based on research and rational expectations; they are acquiring these exposures solely due to their market capitalisation and position in the Index. I would call this “bad” concentration, vs the “good” concentration exhibited by Berkshire Hathaway. It is a naively constructed portfolio, lacking any inherent risk management. As an investor, are you comfortable with this? Are you comfortable with your equity exposure demonstrating this increased duration?

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Is your market exposure changing?

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This evolving index composition has made the market risk premium, or expected return of the market, more responsive to interest rate and inflation shocks. The changing characteristics of the index have therefore influenced how the market reacts to these shocks. A higher duration stock will naturally experience more deviation than a lower duration stock for each unit of “inflation/interest rate shock”. Similarly, just as the Bond Index duration increased after the GFC, the duration of global equity has also risen, particularly following Covid and into the current AI boom.

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Under these circumstances, inflation and interest rate shocks, such as the recent Trump tariffs, may lead to more market volatility than would otherwise occur. The tariff announcements immediately impacted price expectations, potentially affecting inflation and interest rates.

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Long-duration characteristics will add volatility to the index at certain times during the cycle and in periods of heightened uncertainty. With increased uncertainty, the implied discount rate can rise (a sentiment impact). I would posit that uncertainty widens the distribution of outcomes. This is highlighted in the distribution described below as negative kurtosis.

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Oddly enough, if these shocks have a lasting effect, they can lower inflation and interest rates through a growth shock; however, the initial reaction to volatility is to penalise the discount rate while the broader distribution of outcomes is assessed. Most of us refer to this impact as market sentiment.

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As part of this discussion, it is also worth noting that when market valuations are higher than average, as they are today (I am not willing to say expensive here), any negative shocks—combined with the long-duration nature of these stocks, whether through inflation, interest rates, or market uncertainty—all of which impact the discount rate applied to these stocks—may lead to a material decline in the index, depending on the severity and persistence of shocks.

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Risk Mitigation

After providing additional context regarding the risks I perceive in the equity markets under the current circumstances, I will discuss potential methods to mitigate these risks.

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1) Reweighting towards a lower level of absolute risk or volatility to interest rates/inflation.

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A reweighting process can be quite straightforward. Adjust the portfolio duration down towards a more normalised position. If an investor wishes to maintain equity exposure despite understanding the risks in today’s market, this can be achieved by increasing the weighting towards lower duration styles or factors.

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As described above, Growth is a high-duration style, while Value is a low-duration style. An investor could tilt their style exposures towards Value. Adjusting a portfolio's duration can be achieved using ETFs and/or factor portfolios. Although the implementation is straightforward, it requires an analysis of the index's current implied duration and a view as to what level of duration risk is acceptable. This would likely feed back into an active risk budget (tracking error) around the index in today's environment.  

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Several papers have been written on equity duration and how to derive this measure. One such paper is Equity Duration: Theoretical and Practical Analysis authored by Dennis Montagna and Luca Bianchi - University of Pavia - Department of Economics and Management. I note the CFA has also released on paper written by Martin L. Leibowitz, PhD, Eric H. Sorensen, Robert D. Arnott and H. Nicholas Hanson called A Total Differential Approach to Equity Duration.

I would note that it doesn’t matter which measure you use for this exercise, but you must consistently apply the methodology to achieve an outcome that reflects the changes in the Index.

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2) Look to add more active management to help manage the risks noted above.

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Active management can be a valuable strategy to mitigate exposure to the abovementioned risks. Active managers ensure that their portfolio positions are thoroughly researched and incorporate a level of risk management that isn't inherent in any index structure. They seek the best ideas regardless of their position in the market capitalisation hierarchy. Consequently, active management will typically, though not always, have a lower average market capitalisation than the index.  

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Active management also allows for the adjustment and trading of portfolio positions during volatile periods. In an environment where volatility may persist, the ability to trade can provide both a return driver and a risk management tool.

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The key to effectively combining active management strategies to mitigate duration risks is understanding how sensitive any potential active strategy may be to duration. Employing a manager with strong growth characteristics could further introduce duration risk. Therefore, it’s crucial to be aware of the addition's potential characteristics and its interactions with the existing portfolio.

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Implementing active management as a risk mitigant in these circumstances will also require the consideration of the following:

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1) An understanding that more active risk over and above current levels may be required. To achieve the goal of lower duration, an active manager may need increased lenience in tracking error limits. A complete reassessment of active risk budgets may also be required to ensure objectives are met.

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2) Benchmarking. The old adage, "What gets measured gets managed," applies in this circumstance. A duration benchmark may need to be added to any mandate (or other) guidelines to ensure it is being monitored. Benchmark providers could also be approached to design a duration-based benchmark appropriate for the investor that could be used to benchmark managers.

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By their nature, active managers will have portfolios that change over time. For this reason, it is incumbent upon investors to ensure that overall portfolio settings are maintained within required limits. This includes duration restrictions.

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A further positive aspect of using active management is that if markets enter a prolonged bear phase, this is precisely when active management typically adds value to the index benchmark. The converse is also true; if any pullback is only short-lived, it will likely favour the recent trend, which has supported the concentrated nature of the global equity index.  

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Broader Diversification

In the first article, I introduced the possibility of entering a new regime of higher volatility and increasing geopolitical risks, which could adversely affect equity returns, particularly those of a longer duration.

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The volatility observed in March and April highlights the risks to the equity market from the swirling geopolitical winds. However, the market has regained confidence as Trump has rolled back his more aggressive tariff measures. Does this then mark a return to the more muted volatility of recent times? The Ukraine war continues, Trump keeps delivering his rapid-fire executive orders, and a multipolar world continues to emerge. Deficit spending remains high, with Scott Bessent (US Treasury Secretary) recently saying his focus is to grow the economy faster than debt, alluding to a slow reining in of spending.

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If volatility remains emergent and continues to build, it would not be surprising to see the term premium rise again, particularly if Bessent follows through on his recent rhetoric. This could lead to a continuation of the recent correlation between equity and bond returns, which has reduced the effectiveness of traditional portfolio diversifiers. Such an effect would also impact longer duration (growth) stocks, which now dominate the Index.

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In this environment, sovereign bonds may not provide the necessary diversification in a multi-asset portfolio to achieve more consistent returns. Given these conditions, I am more inclined to pursue diversification through both liquid and illiquid alternative investments. However, I will only consider those with specific characteristics. They must have a shorter duration than the equity portfolio; otherwise, they will not sufficiently mitigate the risks I have identified.

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There are numerous strategies in the Alternatives universe, though I would broadly categorise their duration in the following manner:

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1) Commodities—Short Duration: Short-term supply and demand dynamics primarily influence returns, although inflation and interest rate expectations can affect hedging and derivative exposures.

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2) Hedge Funds—Short to Long Duration: They tend to be generally more short-duration in nature. I’m including trend-following strategies here.  

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3) Private Equity—Predominantly Long Duration; however, secondary and other strategies can be utilised to reduce overall duration.

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4) Real Estate – Long Duration. The assets are long-term, with leasing WALE (Weighted Average Lease Expiry) and capitalisation rates influenced by inflation and interest rates.

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5) Infrastructure – Long Duration. Infrastructure is influenced by concession periods and long-term leases; however, as these typically involve operating businesses, cash flows can be impacted by economic factors. Regulated assets typically have the longest duration and are generally considered less economically sensitive, followed by more economically sensitive assets like ports and airports.

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Incorporating shorter-duration strategies and assets into multi-asset class portfolios may provide return streams that are less correlated with those provided by public markets, while also reducing the portfolio’s overall duration. If the risks I have identified were to materialise, Alternatives may offer a broader diversification profile than merely repositioning an equity portfolio. These exposures grant access to a broad range of return streams, many of which can be included in portfolios to enhance diversification.

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I won’t delve into identifying alpha or outperformance here, nor will I discuss the fee debate. I assume an investor is content using alternative strategies, including the fee impost.

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Summary

Understanding duration is essential for effective risk management and informed decision-making in the current volatile geopolitical environment. I've outlined my argument for identifying and mitigating duration-related risks in a portfolio.

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It is also worth noting that the risks I have highlighted may not materialise; the market might continue its recent trend, and interest rates could decline from current levels. In this scenario, your portfolio may underperform if you have only positioned for the risks I have highlighted.

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In writing this article, I hope that investors have become a little more familiar with the multi-dimensional nature of risk and the various strategies for managing it. I also hope this serves as a small source of inspiration for investors to improve their risk management frameworks and processes to better identify unintended risks that might be accumulating in their portfolios.

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Shaun O’Malley, former GM Investments Spirit Super and MTAA‍

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Disclaimer

This article is intended for wholesale investors as defined under the Corporations Act 2001 (Cth) and is not intended for retail investors. The information provided herein is for general informational purposes only and does not constitute financial, investment, or professional advice.

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The views expressed in this article are those of the author and do not necessarily reflect the official policy or position of Kings Gate Capital Partners. While every effort has been made to ensure the accuracy of the information, Kings Gate Capital Partners makes no representations or warranties, express or implied, as to the completeness, accuracy, reliability, suitability, or availability of the information contained in this article. Any reliance you place on such information is therefore strictly at your own risk.

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Investing involves risk, including the potential loss of principal. Past performance is not indicative of future results. Before making any investment decision, you should seek independent financial, legal, and tax advice tailored to your specific circumstances.

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This article may contain forward-looking statements that are subject to risks and uncertainties. Actual results may differ materially from those expressed or implied in such statements. Kings Gate Capital Partners disclaims any obligation to update or revise any forward-looking statements to reflect new information or future events.

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