June 2012

INDEX RESEARCH & DESIGN

THE CASE FOR APPLYING EQUITY DURATION IN PENSION FUND ASSET

ALLOCATION
THE LATEST DURATION OF THE S&P 500
Summary

S&P Indices believes that a diversified portfolio of equities and bonds can be immunized by
leveraging the concept of equity duration, thereby helping to lower the risk of deficits for pension
plans.

Much like the well-known concept of bond duration, equity duration measures the sensitivity of
equities to interest rates. Although this field of research is relatively new and the concept is rarely
used in practice, we believe equity duration can play a significant role in immunization, risk
management and asset allocation.

The simple model of equity duration that we developed and discussed in our 2004 paper, Using
Equity Duration in Pension Fund Asset Allocation, uses the dividend discount model and
incorporates the sensitivity of growth to rates. Based on our empirical model, duration (or
interest-rate sensitivity) is higher for high-growth stocks, stocks whose dividend growth is not
sensitive to interest rates and stocks in low-discount-rate environments.

Annually, S&P Indices publishes an updated report and history of duration for the S&P 500. We
acknowledge that equity duration estimation is an evolving science. We also believe that a
regularly available and updated source of equity duration data will make this important metric
more accessible for further research and practitioner use.

Based on our model, we estimate the duration of the S&P 500 to be 25 years as of year-end
2011. This estimated duration has retreated substantially from the previous peak of 45 years in
2008, but has risen from the low of 21 years in 2010.

The rise in equity duration in 2011 from the 2010 low can be attributed to the quick rebound in the
dividend growth rate.

Contributors:
David M. Blitzer, Ph.D
Managing Director
david_blitzer@sandp.com

Frank Luo
Vice President, Index Research & Design
frank_luo@sandp.com

Aye Soe
Director, Index Research & Design
aye_soe@sandp.com

Electronic copy available at: http://ssrn.com/abstract=2085954

The Latest Duration of the S&P 500

JUNE 2012

EQUITY DURATION
In fixed-income analytics, duration is a standard and ubiquitous measure of the price sensitivity of a bond to
interest rate changes. Similarly, equity duration measures the sensitivity of equity prices to interest rate
changes. 1 The extension of the duration concept to equities is relatively recent, with the earliest literature on the
subject dating back just over 20 years. Its use in investment management is far from widespread and there are
two primary reasons for this:

Unlike bonds, the terminal value of equities is not fixed.

Interest payments of bonds are predetermined and known in advance, while dividend payments of
equities are uncertain.

As suggested in our 2004 paper, the difficulties associated with estimating equity duration do not detract from its
importance in immunization, tactical asset allocation and risk management.
Immunization: Immunization refers to a form of investing that allows an investor to match assets and liabilities
regardless of changes in interest rates. It refers not only to matching the present value of assets with the present
value of liabilities, but also to matching the interest rate sensitivities of assets with those of liabilities. Since the
duration of any instrument varies with time and changes in rates, complete immunization is costly and impractical.
For this reason, immunization in practice is often a tradeoff between cost and efficiency. A pension plan can
benefit from immunization as it not only must match its present value of assets with its projected obligations, but
also must ensure that the durations of its assets match those of its obligations. Since equities account for nearly
half of the assets in most pension plans, an estimate of equity duration is important.
Risk Management: Equities constitute a significant portion of investors portfolios, and empirical evidence
suggests that equities do react to changes in rates. Therefore, any risk management plan needs to factor in the
sensitivity of the equity portfolio to rate changes.
Tactical Asset Allocation: Tactical asset allocation makes opportunistic predictions about changes in the
external economic environment by shifting allocations among different asset classes. Since interest rate changes
are one indicator of the external economic environment, knowledge of equities rate sensitivity would be very
important for plan managers who are considering shifts in asset allocations in order to take advantage of
projected changes in interest rates.

EVALUATING EQUITY DURATION

There are three distinct approaches to evaluating equity duration. 2 While the dividend discount model approach
is the earliest and simplest, it gives high estimates of equity duration. More importantly, the approach fails to
account for the flow-through effects of interest rates; that is, it does not consider the fact that growth might be
sensitive to rates. The empirical approach, on the other hand, derives equity duration from historical changes in
equity prices and interest rates. While statistically appealing and direct, the empirical approach suffers from
biases that result in lower-than-expected estimates of duration. Flow-through duration models follow from the
dividend discount model, but also factor in sensitivity of growth to rates. In our calculations, we use a flowthrough duration model to derive our estimate of equity duration:
1/P (P/k) = -1/(k-g) (1-g/k)

(1)

Where P is the price of the stock, k is the equity discount rate, and g is the dividend growth rate.

It is important to note that, unlike in bonds, interest rates do not have significant explanatory power for equity returns.
Rather, the rate effect is transmitted to equity prices through other variables that have significant explanatory power.
2
See our previous paper for a more complete description of these approaches and historical estimates derived from
them: http://www.spindices.com/assets/files/sectors/pdf/using-equity-duration-in-pension-fund-asset-allocation-2004.pdf

McGRAW HILL

Electronic copy available at: http://ssrn.com/abstract=2085954

The Latest Duration of the S&P 500

JUNE 2012

This is a simple flow-through model, where g/k measures the sensitivity of dividend growth to changes in the
equity discount rate. Ceteris paribus, several properties of duration can be drawn from this approach.
1. Higher growth implies higher duration. That is, higher-growth portfolios will have a higher duration and,
therefore, greater sensitivity to interest rates.
2. If the dividend growth rate is steady, a higher equity discount rate implies a lower duration and, therefore, a
lower sensitivity to changes in interest rates.
3. Low sensitivity of growth opportunities to the discount rate increases the duration of a portfolio and, therefore,
increases the sensitivity of a portfolios value to changes in interest rates.
In our calculations for evaluating the duration of the S&P 500, g was defined as the quarterly dividend growth of
the S&P 500. For k, we used the Moodys Seasoned Baa Corporate Bond Yield series. The choice of a
corporate bond yield series departs from the literature, but we believed it to be more practical than the use of a
long-term (ten- or 20-year) Treasury bond. Traditionally, the equity discount yield in this context has been defined
as the yield of a long-term Treasury bond with a constant equity risk premium added to it. However, because the
equity risk premium varies from one time period to another, an average might not be appropriate. The corporate
bond series provides a market-determined, risk-adjusted measure of the discount rate.
The sensitivity of g to k is difficult to estimate. Following some prior literature, we took this factor (g/k) as the
correlation of change in g to change in k. We use averages for the past 40 quarters (ten years) for 1973 through
2005, and averages for the past 80 quarters (20 years) for 2006 through 2011. For the g/k term, we use the
correlation of change in g to change in k for the previous 40 quarters for 1973 through 2005 and the previous 80
quarters for 2006 through 2011. We lengthened our smoothing function for the years 2006 through 2011 to 20
years in order to correct for the anomalous past ten years.

UPDATED DURATION ESTIMATES

The duration of the S&P 500 since 1973 is shown in the Appendix and charted in Exhibit 1. We estimate that the
duration of the S&P 500 was 25 years at the end of 2011. After rising precipitously since 2003 and reaching an
all-time high level in 2008, equity duration has declined substantially and is now close to the long-term historical
average level of 23.7 years. The decline is attributable to a combination of factors: falling discount rate and
dividend growth rate, together with a decrease in the sensitivity of the dividend growth rates to the change in tenyear rates (g/k). An explanation of the effects of each key variable follows.
As noted in our previous papers, the first quarter of 2004 through the first quarter of 2008 saw one of the longest
sustained periods of double-digit dividend growth. After exhibiting a growth rate of 11% in June 2008, dividend
growth contracted to its all-time low of -21% in December 2009 as corporations across the index slashed
dividends. Since then, the dividend growth has rebounded quickly as corporations quickly repaired their balance
sheets. The dividend growth of 16.3% for 2011 is near the historical high. Since we measure our growth
parameter, g, as the growth rate in dividends, the increase in dividend growth rate is reflected directly in the
increase of the equity duration estimation.

McGRAW HILL

Electronic copy available at: http://ssrn.com/abstract=2085954

The Latest Duration of the S&P 500

JUNE 2012

Exhibit 1: Duration of the U.S. Equity Market

Source: S&P Indices. Estimates are for the middle of each calendar year. Data for 2011 was calculated as of the end of 2011. Graphs are
provided for illustrative purposes. Past performance is not a guarantee of future results.

The discount rate is also an important input in our model. Following the second quarter of 2007, rising volatility in
the equity market, as evidenced by the CBOE Volatility Indexs (VIX 3) historic high of 59.8 in October 2008 and
the subsequent tightening of credit markets, led to higher corporate bond yields. Owing very much to the
aggressive policy actions undertaken by the Federal Reserve and other central banks, overall credit market
conditions started to improve slowly in the first quarter of 2009 and bond yields began to decline gradually.
Currently, the discount rate stands at a historical low.
Since our model is highly sensitive to the difference between growth (g) and the equity discount rate (k), it is
useful to see how they have varied over time. Exhibit 2 charts the values of k and g through time. One notable
observation is that g was greater in magnitude than k from the first quarter of 2004 through the third quarter of
2008. Theoretically, such a situation would lead to absurd results: stock values would be bid continually higher if
dividends could continue to grow faster than the required rate of return on equity. From an empirical perspective,
however, dividends cannot continue such growth, despite the fact that the growth stretch from 2004 through 2008
was the longest in our data. In fact, the records since the first quarter of 2008 show the sharpest decline in
dividend growth. Exhibit 3 tracks the value of the difference between the ten-year averages of k and g through
time, and shows that it has rebounded from the lowest levels recorded. The dip in (average k average g) since
2009 contributes to the rebound of our duration estimate.

VIX is a registered trademark of the Chicago Board Options Exchange, Incorporated. The VIX methodology is the
property of the Chicago Board Options Exchange ("CBOE").

McGRAW HILL

The Latest Duration of the S&P 500

JUNE 2012

Exhibit 2: Model Inputs through Time

Source: Moodys, S&P Indices. Data as of December 31, 2011. Graphs are provided for illustrative purposes. Past performance is not a
guarantee of future results.

Exhibit 3: DDM Denominator (k-g) with Ten-Year Averaging

Source: Moodys, S&P Indices. Data as of December 31, 2011. Graphs are provided for illustrative purposes. Past performance is not a
guarantee of future results.

McGRAW HILL

The Latest Duration of the S&P 500

JUNE 2012

The third important variable in our model is the sensitivity of dividend growth rate to changes in the long-term
interest rate. Our analysis indicates that the sensitivity factor, g/k, has fallen since our last measure.
According to the equation (1), a lower sensitivity of growth opportunities should increase duration, all else equal.
The decline of the sensitivity factor has contributed to the increase in the duration measure since the last update.

MEASURING DURATION USING AN EMPIRICAL APPROACH

Using the empirical method, based on regression results of the S&P 500 quarterly returns against the changes in
the ten-year rates, we estimate the duration of the U.S. equity market to be 8.83 as of 2011 year end. This rate
has declined slightly since mid-2010, when the rate was 9.63. As expected, the empirically-derived estimate of
equity duration is lower than the estimate derived from our flow-through model. However, as we have noted in
previous papers, the empirical method does not account for the fact that part of the explanatory power of the
slope coefficient is present in the constant term, thereby resulting in the beta coefficients downward bias. 4
Furthermore, the direction of change predicted by the empirical model contradicts that of our flow-through model.
While the empirical duration method shows that duration declined between 2010 and 2011, the flow-through
model estimates that duration increased over this period. Despite the inconsistency, the empirical duration
method is still useful for measuring the short-term sensitivity of an equity portfolios returns to changes in longterm interest rates.

CONCLUSION
Our flow-through duration estimate incorporates long-term parameters and would therefore be inappropriate for
short-term market timing. It is intended to provide context for long-term asset allocation involving rebalancing
every three years or more, which is consistent with the asset allocation review cycles of most pension plans. The
trend should be considered as important as the point estimate. Therefore, in the Appendix, we have added a
three-year moving average column. In light of this, it would be inaccurate to interpret the December 2011
duration estimates as indicating that the S&P 500 would fall 25% for every 1% rise in rates. Rather, a more
appropriate way of interpreting the estimate is that the duration of the S&P 500 would be 25 years if it were a
fixed-income instrument discounted at its appropriate risk-adjusted rate.

Please refer to our previous paper for detailed explanations of the limitations of the empirical estimate:
http://www.spindices.com/assets/files/sectors/pdf/using-equity-duration-in-pension-fund-asset-allocation-2004.pdf.

McGRAW HILL

The Latest Duration of the S&P 500

JUNE 2012

APPENDIX: ANNUAL DURATION OF THE S&P 500

Year

Duration of U.S. Equity Market

12-Quarter Moving Average of Duration

1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010

36.4
30.6
23.9
17.8
22.9
30.2
33.8
31.5
39.0
39.5
29.1
21.9
21.2
21.4
16.0
13.3
12.8
14.9
14.2
14.2
17.2
19.9
17.1
19.6
25.0
24.2
23.4
18.5
15.0
16.0
15.2
17.5
24.9
27.9
35.4
42.6
34.0
21.0

26.0
22.2
22.7
27.1
30.8
33.8
36.2
36.4
32.4
26.2
22.5
20.4
17.9
15.1
13.7
13.8
14.2
14.9
16.3
17.3
18.2
19.7
21.9
23.3
22.5
19.7
16.9
15.4
15.8
18.1
22.2
27.5
33.3
38.2
35.4

2011

25.0

29.1

Source: S&P Indices. Estimates are as of the middle of each year. Data for 2011 calculated as of the end year. Tables are provided for
illustrative purposes. Past performance and correlations are not a guarantee of future results.

McGRAW HILL

The Latest Duration of the S&P 500

JUNE 2012

The duration estimate is obtained from the formula provided in equation (1), with equity duration being equal to
-1/(k-g) (1-g/k). We define g as the annualized quarterly dividend growth of the S&P 500. For k, we choose to
use the Moodys Seasoned Baa Corporate Bond Yield series. We use averages for the last 40 quarters (ten
years) for 1973 through 2005, and averages for the past 80 quarters (20 years) for 2006 through 2011. For 1973
through 2005, the g/k term is defined as the correlation of change in g to change in k over the previous 40
quarters and for 2006 through 2011, it is defined as the correlation of change in g to change in k over the previous
80 quarters.

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The Latest Duration of the S&P 500

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