Rate sensitivity in equity portfolios

Typically, the equity portfolio is modelled using a benchmark. Using an example of a Canadian equity portfolio, I’ll use the S&P/TSX Composite Index for the purpose of determining the proper allocation to this asset class. It would be important, therefore, for the actual portfolio characteristics to resemble that of the index. Since there has been a focus on dividend-paying stocks of late, I’ll use the S&P/TSX Dividend Aristocrats Index as a proxy for a portfolio that is heavy on dividends, and we can compare its characteristics to that of the S&P/TSX Composite.

For purposes of computation, the data begins in October 2008, shortly after the creation of the Dividend Aristocrats Index.

From the table above, notice that the Dividend Aristocrats Index provided a significant value add for a marginal increase in risk. Calculating the correlation of the two portfolios, the correlation of monthly returns is approximately 0.94, meaning that they tend to move uniformly. At this point, you may assume that the S&P/TSX Dividend Aristocrats Index would be a suitable portfolio replacement for the S&P/TSX Composite. However, you must be aware of how each of these indexes performs relative to other asset classes in your portfolio.

In this table, we look at the correlation of both indexes to bonds, represented by the DEX Universe Bond Index:

Note that both the S&P/TSX Dividend Aristocrats and the S&P/TSX Composite are negatively correlated with bonds. However, as might be expected, the Dividend Aristocrats Index exhibits slightly less negative correlation, given that its expected cash flow stream more closely resembles bonds than the Composite Index.

In general, it appears that the S&P/TSX Dividend Aristocrats Index may be a reasonable replacement for the S&P/TSX Composite Index as a proxy for a dividend portfolio. However, this may not apply to other high-yield equity funds. Looking at how interest-sensitive areas of the equity market performed relative to the Composite Index, some groups were not as closely aligned to the Composite Index as the Dividend Aristocrats Index.

The following charts look at metrics for interest-sensitive S&P/TSX equities, usually denoted by their inclusion in the utility, telecommunication, real estate investment trusts (REITs) and pipeline groups in comparison with the S&P/TSX Composite Index and the Dividend Aristocrats Index.

Source: Greystone Managed Investments

Source: Greystone Managed Investments

From these charts, the Dividend Aristocrats Index more closely resembles the Composite Index than any of the other interest sensitive groups. For example, pipelines exhibit similar returns to the Composite Index but exhibit greater volatility and much lower correlation, which could lead to high deviations from the index. This would be inconsistent with the premise of allocating to equities, which is based on index performance assumptions. REITs, on the other hand, lag the index in terms of returns and volatility and are highly correlated with the index, but exhibit a slightly positive correlation to bonds in contrast to the index, which has a -0.22 correlation with bonds. Positive correlations of REITs to bonds could lead to unexpected losses relative to the Composite Index if interest rates rise.

It’s important to understand the assumptions of an asset-liability study and to ensure that the actual investments adhere to those assumptions. Investing in interest-sensitive equities has become more popular for pension fund managers. Proper construction of a dividend portfolio is imperative to ensure that the pension fund achieves the objectives of return and risk it expects from its equity portfolio.

In the next article of the series, we will look at Step 3: ensuring the equity portfolio exposure to other factors is not negatively skewed.