The Hidden Bond Exposure In Equity Portfolios


One of the lessons from the financial crisis is the importance of checking your portfolio’s exposure to different risk premia instead of just assuming that asset classes are uncorrelated: correlations not only exist, they have a way of getting stronger exactly when you hope they wouldn’t. With that in mind, long-only equity investors might have trouble identifying the source of recent market volatility, but according to risk management firm AlphaBetaWorks it’s their hidden exposure to the bond market that is shaking things up.

“An equity portfolio with no bond positions is still exposed to the bond market,” AlphaBetaWorks writes on its blog. “Over the past five years 20% of US equity market volatility can be explained by a negative correlation to the US Bond Index.”

Bond Exposure us mrkt returns v bond index 1114

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Falling bond prices explain a third of Russell 3000 2013 gains: AlphaBetaWorks

On top of stock-specific bond exposures (eg highly leveraged companies), it makes sense for stock and bond prices to be inversely correlated since both are related to interest rate and inflation expectations. If you expect rates to go up then you should be willing to pay more for bonds, but you would also use a larger discount factor when pricing stocks. When the reverse is true, you would expect bond prices to fall and stock prices to go up as we saw this year: AlphaBetaWorks says that, “the 5.4% decline in bond prices explains over a third of the 31% Russell 3000 return in 2013.”

But that doesn’t mean you have no control over the level of exposure. If you wanted to be more positively exposed to bond prices you could focus your investments on large caps, or allocate more to small caps to get the opposite effect. Whichever you prefer, it’s important to be aware of these asset correlations when putting a portfolio together.

Bond Exposure size factor v bond index 1114

Longleaf, ESL Investments have largest short bond exposure

What’s true for individuals is no less true for the smart money (though you hope they’re more aware of the correlations). On average, bond prices explain 0.5% of US mutual fund variance and nearly 2% for hedge funds, but that number is much, much higher for some funds. In some cases, bond risk is the second largest factor behind market exposure effecting equity portfolio variance.

To test for hidden bond exposures, AlphaBetaWorks regresses individual stock returns against the market to get market residuals, regresses those market residuals against sector-specific factors to get a sector residual, and then regresses sector residuals against a bond index to estimate the beta of stocks to bonds. Putting that information together with a hedge fund’s stock portfolio tells you what bond exposure it already has before it even starts buying bonds directly.

Bond Exposure mutual fund performance factors 1114

Bond Exposure hedge fund performance factors 1114

Longleaf Partners Small Cap Fund and Royce Opportunity Fund are the most effectively short bonds, with their short bond exposure greater than their total AUM according to AlphaBetaWorks, while T Rowe Price Media & Telecommunications Fund is the most long.

Bond Exposure equity mutual fund long bond exposure 1114

equity mutual fund short bond exposure 1114

Among hedge funds ESL Investments Inc is the only one approaching short exposure on par with AUM, and Cushing MLP Asset Management has the largest long exposure according to AlphaBetaWorks research.

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hedge fund long bond exposure 1114

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