The financial media are full of conjecture about which strategies might effectively hedge inflation risk or not. Here we explore which asset classes, if any, have been effective at protecting against inflation risk. First, it is helpful to address some common logical and analytical misconceptions about hedging inflation risk.
Focus on Correlation, Not Volatility
When evaluating whether an asset class effectively protects against inflation, the focus should be on the correlation between that asset class’s returns and inflation and not the relative volatility of the asset class’s returns when compared with the volatility of inflation. This misconception often leads to assumptions, such as commodities as an asset class cannot effectively hedge inflation because its returns are about 8–10 times more volatile than inflation. This is simply false.
For example, if commodities were perfectly correlated with inflation but had returns that were 10 times more volatile than inflation, it would still be a perfect hedge against inflation risk. In that case, a 10 percent allocation to commodities with the balance of the portfolio in short-term fixed income would be very close to a perfect hedge. We recognize that commodities are not perfectly correlated with inflation and therefore are not a perfect hedge. The point, however, is that correlation is what matters and not relative volatility.
Focus on Correlation, Not Returns
Another common error is categorizing an asset class such as equities as a good inflation hedge because its long-term returns have been significantly higher than the rate of inflation. Here again, correlation is what matters. The reality is that equities have had very low correlation with inflation over almost all time horizons. If your spending is highly correlated with inflation, the fact that equities eventually should outpace inflation is not nearly as helpful as knowing that an asset class tends to do well at the exact same time inflation is high.
There Are No Perfect Inflation Hedges
Although there are no perfect hedges against inflation risk, this, however, does not mean it is a waste of time to explore which asset classes can provide some protection against inflation. There are meaningful differences in inflation protection across different asset classes.
Further, even though individual rates of inflation are often significantly different from the consumer price index (CPI) rate of inflation, they are likely highly correlated with CPI. This means asset classes with attractive inflation hedging properties are generally useful to investors who are highly exposed to this risk.
Evaluating Inflation Hedges
We examined the returns of 10 different asset classes relative to CPI inflation from the period covering January 1981–December 2013, and the period covering September 2002–December 2013.* (Our definition of “hedge” is general, and it is not meant to imply that any asset class is a perfect hedge.) The only asset class that did a decent job of hedging monthly inflation over this period was commodities. The two asset classes that tended to perform the worst were two-year and 30-year Treasury notes with 30-year Treasury notes doing significantly worse than two-year Treasury notes.
The results over the shorter time period included Treasury Inflation-Protected Securities (TIPS), and we found that commodities and short-term TIPS both did a decent job of hedging monthly inflation risk. Also, there is some evidence that the relationship between inflation and the returns of certain asset classes tends to strengthen over longer horizons. Note that equities, REITs, gold and foreign currency did not have a consistent relationship with inflation and therefore have not been good hedges of inflation.
Overall, these results suggested that only two asset classes have consistently protected against inflation over relatively short horizons: short-term TIPS and commodities.
*Asset classes included are as follows: U.S. stocks (proxied by S&P 500 Index), international developed stocks (proxied by MSCI EAFE Index), short-term bonds (proxied by 2-Year Treasury notes), long-term bonds (proxied by 30-Year Treasury notes), short-term TIPS (proxied by TIPS 0-5 Year Maturity Index), TIPS (proxied by Full TIPS Index), commodities (proxied by S&P GSCI Index), real estate (proxied by Dow Jones U.S. Select REIT Index), gold (proxied by spot gold prices from the Federal Reserve) and foreign currency (proxied by USD$ Index).
This commentary originally appeared June 2 on MultifactorWorld.com
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