How to Think About Shortening Equity Duration

Some clients are familiar with duration as it pertains to bonds and if they’re not yet in that camp, chances are advisors are getting them there this year owing to the widely documented punishment in the fixed income.

Fortunately for clients and novice investors, the concept of duration in fixed income parlance is easily explained. It simply refers to a bond’s sensitivity to interest rate changes. The longer the duration on an individual bond or a bond fund, the  more vulnerable that instrument will be to rising interest rates. Conversely, longer duration fare offer more upside when rates decline.

Here’s where things can get confusing to many clients and new investors. Duration principles are also applicable in the world of stocks. Fortunately, the principles are the same. When interest rates are rising, as is the case today, it’s preferable to engage shorter duration equities.

Companies with shorter duration stocks have more immediate cash flows – a favorable trait in today’s environment. Conversely, a longer duration equity is usually tied to a company with further out cash flows, many of which are growth firms, and that increases vulnerability as rates rise.

More Than Just Avoiding Growth Stocks

It’s not uncommon for value stocks to fit in the short duration category and that goes a long way toward explaining value is outperforming growth and the broader market this year.

However, embracing short duration stocks isn’t as simple as loading up on a domestic value fund and calling it a day. In fact, advisors should articulate to clients there are advantages to looking beyond the U.S. in search of low duration stocks.

“Short duration stocks dramatically outperformed both long duration stocks and the overall MSCI World Index when bond yields climbed from their low in August 2020. However, short duration stocks lagged the overall index and their long duration peers when yields retreated slightly (from April through December of 2021), highlighting a risk to this theme,” according to Charles Schwab research.

Data confirm that when searching for short duration stocks, the U.S. isn’t the best place to be.

“Low price to cash flow stocks can be found in all sectors and countries. But they tend to be more concentrated in the indexes of international markets,” adds Schwab. “Although 39% of the 1,539 stocks in the MSCI World Index are U.S.-based companies, U.S. stocks make up 59% of long duration stocks and only 31% of short duration stocks. The remaining short duration stocks (69%) are international companies.”

Consider Different Approaches

Just as it’s not as simple as merely embracing value as an avenue to short duration equities, it’s not easy as allocating to any old international strategy and hoping for the best. After all, the MSCI EAFE Index is performing as poorly as the S&P 500 this year.

Solid starting points are to focus on strategies that overweight the financial services and materials sectors.

“An equal-weighted portfolio only consisting of the 20% of stocks with the lowest price to cash flow contains stocks from all sectors, but would lead to sizable underweights in information technology and health care, with overweights in materials and financials, relative to the MSCI World Index,” concludes Schwab.

Other ideas to consider are international dividend and low volatility funds, which usually feature large amounts of amount of short duration stocks and some of which are beating the MSCI EAFE Index this year.

Related: Delivering Your Portfolio From the Bond-Age