Some investors have had a meteoric rise to fame over the last few years due to the incredible performance of their funds. Specifically, some of these funds have their investments in stocks ranging from AI to electric vehicles to gene editing companies. For some of these funds, their investment propositions are based on being able to identify future trends, and outperformance was credited to stock picking ability. However, many of these investments have unravelled in recent months. As time has gone by, the question of the source of outperformance becomes more glaring, with one major possibility being that a significant source of fund outperformance could simply be more a function of one thing: equity duration.
Equity duration is the cash-flow weighted average time at which cash flows from a company are received. Given that the majority of stocks mentioned above are focussed on future technologies, not many of them are expected to generate meaningful cash flows in the near-term. When cash flows of companies are further into the future, the valuation of these companies becomes more sensitive to changes in interest rates. That is because the higher the interest rate is, the lower the current value of those discounted cash flows will be. Many of these stocks are either pre-revenue or unprofitable, meaning no cash flows were expected in the near-term. This led to funds that held these stocks being extremely long duration.
When the Covid crisis happened and the Fed rapidly cut rates to zero, the market re-rated companies with cash flows further into the future more than ever before. This caused these types of stocks to skyrocket. In this scenario, any fund with a significant weighting in these long duration stocks would have performed extremely well. In a way, one could say that stock picking was being confused with a bet on the direction of interest rates.
In the last few months, the opposite has occurred as to what happened at the start of Covid. As the market prices in an increase in interest rates, these stocks have declined substantially, giving back their outperformance on their benchmarks. If one blindly sticks to this strategy regardless of what is happening in the world, these funds just become duration plays with the path of interest rates determining the funds’ future performance. Unfortunately for these funds, it currently looks as if the path of rates is upwards and these funds are likely to continue to underperform until that changes.