Style Selection and U.S. Investors’ Risk Appetite

Abstract

The authors believe that the prevailing Treasury term structure gives important information about the desired investment time horizon of investors. They equate this time horizon to the implied duration of liabilities of a representative investor and estimate this target duration over the post-war period using monthly zero coupon yield-curve data provided by the U.S. Federal Reserve. In their view, mismatches between actual and target duration provide a measure of risk appetite. The authors test this hypothesis with a simple model that uses target duration to predict periods of outperformance of U.S. stocks over U.S. Treasury bonds and hedge funds over CTAs (commodity trading advisors). The model generates attractive risk-adjusted returns with minimal parameterization.