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Christian Mueller-Glissmann, a managing director at Goldman Sachs focused on asset allocation in the Global Investment Research, has long been an advocate of dividend futures. In this article he talks to Eurex about the new market paradigm for asset allocation with more duration risk in portfolios and how dividend futures can be used as a tool to create alpha during periods of rising bond yields and falling equity valuations.
Eurex: You have written about the “equity duration puzzle” emanating from the performance of bonds and equities in recent years. Can you explain what the puzzle is and what you mean by longer equity duration?
CMG: What we have seen since the Global Financial Crisis in 2008/09, but in particular in the recovery from the COVID-19 shock, is that the duration risk embedded in equity portfolios has increased materially. This is down to higher equity valuations and the material outperformance of growth vs value stocks, both last year and in the last cycle. Over that period, bond yields have trended down, continuing the bond bull market that started in the 1980s and investors are increasingly worried about secular stagnation and the scarcity of growth. That has driven more investment in, and outperformance of, stocks with long term, secular growth potential - such as tech or renewable energy companies. This has led to a lengthening of duration for most equity indices. The cashflow and dividends coming back to shareholders from these companies in the near term is often low and so the market is paying more for the future cashflows. The lower the dividend yield, the more of the present value of expected cash flows is in the future – thus equity duration has increased both with higher valuations and lower dividend payout ratios. This is particularly the case for the US equity markets, where there is a larger weight of such low-yielding growth stocks.
What does that mean for asset allocators?
Duration risk in portfolios, both in fixed income and equities, is likely to be higher. What is means is that, for example, a US 60% equities and 40% bond portfolio is currently potentially more vulnerable to rising bond yields, especially with an unfavorable growth/inflation mix. But it is not just the rate sensitivity that people should be focused on. If an asset allocator owns long duration stocks, they are more exposed to rate shocks but also to changes in the equity risk premia. The equity duration doesn’t measure changes to yield in the bond market, it measures the sensitivity to changes in the cost of equity, which is a combination of bond yields and the equity risk premium. So the interaction between the two matters critically – if the equity risk premium goes up for any reason it can hit the equity markets to a greater extent than has historically been the case, especially as bond yields might not decline much from their current low levels.
Why might we see an increase in equity premia?
Of course, during a bear market and a large increase in risk aversion, you would see equity risk premia soar. But even outside of that, the market is noticing that equities have become riskier, which might also put upward pressure on equity risk premia over time. The volatility since the COVID-19 recovery began has been elevated – the VIX, for example, has struggled to decline below 20 and has thus stayed well above the average in the last cycle of around 15 and an average realized volatility of about 12 for the S&P 500. Some think this means the VIX is too high and often coming out of bear markets, volatility risk premia (the spread between implied and realized volatility) remain elevated. But another way to interpret the higher VIX is that it is signaling that, considering higher equity valuations and longer duration, equities are riskier than historically at this current juncture. And if equities are riskier, that requires a higher risk premia.
Current elevated absolute equity valuations are an important difference compared to the start of the last cycle, post the GFC, when equities were attractive vs. bonds and valuations were lower on an absolute basis. The equity market today has some similarities to the Tech Bubble in that there has been a leadership of and concentration on secular growth stocks. Of course, during the Tech Bubble long-term growth expectations were much too bullish and, very differently, today there are some very strong, profitable large-cap companies in the growth segment. Still, higher valuations increase risk for the simple reason that there is less of a buffer for shocks.
What might be the trigger for that?
A number of things could ultimately trigger a reframing of equity risk premia and absolute valuations. It could be triggered by a reaction to higher rates and a shift in the inflation regime, which has been the case since the beginning of the year, or disappointments from some of the secular growth companies, including taxes and regulation. Ultimately the long duration in equities is changing the rate sensitivity and duration risk in a portfolio but it also changes the risk embedded in equities. This is something that investors needs to be aware of and manage more actively. We have seen corrections in equities become sharper and faster. This negative convexity is also in part linked to valuations and, to a larger extent, market microstructure and it might mean that equities are much more volatile this cycle than in previous ones.
You have been a pioneer of dividend futures; how can investors use them to manage equity duration risk?
Dividend futures allow you to manage duration risk within equity portfolios and can reduce exposure to changes in equities valuation and enable investors to lower duration. Our research has shown that if you systematically buy the next 10 years of dividend futures risk-adjusted returns are often better compared to an equity investment, especially in markets and periods with positive dividend growth. However, in a bear market or profit recession, the dividend futures often underperform equities as a recession hits short-term cashflows. In part, pressure on dividend futures during those times has also been exacerbated by supply/demand imbalances from structured products issuance. Either way short duration assets, such as dividend futures or value stocks, are more sensitive to near-term cashflow shocks but much less sensitive to changes in rates and in the equity risk premia. So far, dividend futures have predominantly been used to benefit from discounted levels in periods of market stress and due to structural supply and demand imbalances. They should be seen as an instrument that will outperform equities in the longer-term during periods of rising rates and inflation and falling equity valuations. Dividend futures are currently underappreciated in terms of their ability to help manage duration risk, but we expect this to change over the coming months and years.
We look forward to discussing these topics at the upcoming Derivatives Forum Frankfurt 2021 on March 23-24.