A Diversified Real Asset Approach for Managing Future Inflation Risk (from PIMCO website)
Viewpoints
April 2010
In the wake of the financial crisis, more investors are seeking ways to diversify the equity risk that has historically dominated their portfolios while also finding ways to guard against the pernicious effects of inflation that may pose a significant long-term risk.
The result: a renewed interest in real assets, which are distinguished by their returns being either explicitly or implicitly linked to inflation. The most liquid options are inflation-linked bonds (including Treasury Inflation-Protected Securities, or TIPS), commodities, real estate investment trusts (REITs) and commodity-related equities. Less liquid options include private real estate, timber, oil and gas partnerships and infrastructure-backed equity and debt.
Rather than making multiple real asset allocations, investors may find that a “one-stop” diversified real asset strategy provides the concurrent benefits of strategic exposure to multiple real assets, and active management of both the mix and the individual investments. A single allocation to a mix of investments that may collectively provide a hedge against inflation driven by a rise in generalized prices, due to rising interest rates, commodities prices and/or housing costs may be a good fit for many investors. This approach also works to eliminate the need for investors to perform exhaustive due diligence on multiple sectors, investment managers and individual products.
Job No. 1: Decide Which Asset Classes
Three of the most important components of a well-constructed diversified real asset strategy are liquidity, the potential to diversify (versus amplify) risk, and a sense of how the holdings generally respond to inflation.
Considering these issues quickly narrows down the list of appropriate asset classes. Illiquid assets typically aren’t appropriate for a core real asset allocation. This leaves the more liquid assets, including inflation-linked bonds, commodities, REITs and commodity-related equities as candidates.
Because the shares of REITs and commodity-related equities are both stocks, they can amplify (rather than diversify) existing equity risk in a portfolio. If the increase in equity risk is modest and also provides a distinct inflation hedging capability, it may be worth the additional equity risk. This tends to be the case with REITs, which are the only liquid proxy for real estate. Since housing represents over 40% of the U.S. Consumer Price Index (CPI) as of February 2010, investors concerned with inflation should look to establish a hedge against real estate inflation.
While equities of companies in commodity-related businesses (such as shares of mining companies, for example) can provide an inflation hedge, we feel the better hedge is through an investment in commodities directly. A direct allocation to commodities is preferable because it provides the inflation hedging exposure while eliminating the incremental equity risk. This can be efficiently accomplished through a strategy that tracks a broad index of commodity futures, such as the Dow Jones-UBS Commodity Index. So we think investors should include REITs, TIPS and commodities in a diversified real asset strategy, but exclude commodity-related equities.
Different Assets for Different Hedges
TIPS, commodities and REITs each may provide a hedge against inflation, though they respond differently depending on the drivers of inflation.
TIPS, which are U.S. government bonds with principal and interest that track changes in the CPI, provide inflation protection based on this direct linkage to actual inflation. They also offer an incremental real yield, so as to grow investors’ purchasing power regardless of future inflation. Therefore, TIPS are a good inflation hedge regardless of the driver of inflation, as long as that is concurrent with range-bound or decelerating real growth expectations. That’s because rising growth expectations tend to push real yields higher, which causes price losses on TIPS that can offset their inflation linkage and real yield.
Commodities may provide a hedge against inflation based on their ability to capture changes in expected future prices for a range of key consumables, such as energy, industrial metals, precious metals, agricultural products and livestock. Investing in commodities futures is similar to being “long” price volatility in these goods, so it can be an effective inflation hedge when inflation is driven by marked increases in global growth (higher demand) or declines in commodity inventories (lower supply).
Finally, REITs may provide a hedge against inflation based on their ability to extract levered equity returns from another key inflation driver: real estate rents. In economic environments where lease rates increase over time, reflecting real estate inflation, REITs generate higher income, which can drive REIT prices higher. Thus, REITs can be effective as a hedge when inflation is driven by the real estate sector. REITs can also be attractive in economic environments that are attractive for equities in general, such as those characterized by range-bound inflation and steady GDP growth.
What Size Allocation?
Another factor to consider when constructing a diversified real asset strategy is the size of the allocation to each of the complementary inflation hedges. The two most important issues are the level of overall volatility targeted for the strategy and the desired mix of exposure to the different types of inflation hedges provided by each real asset.
Regarding volatility, the tradeoff is straightforward. Too low a volatility target and the portfolio mix overwhelmingly skews toward TIPS. Investors would lose the diversified inflation hedging exposures of commodities and REITs, plus the total strategy wouldn’t have much diversification effect against core stocks and bonds, which tend to dominate portfolios.
Too high a volatility target suffers from the opposite challenges. The portfolio mix would skew toward commodities and REITs at the expense of TIPS. Furthermore, while the higher volatility level would provide more inflation hedging “zig” to help diversify the “zag” of traditional investments, investors may view the investment as too risky on a stand-alone basis.
Though there is no single “optimal” mix, a one-third weighting each to TIPS, commodities and REITs provides a benchmark that, based on PIMCO’s analysis, should provide an attractive balance of total volatility, return potential, diversity of exposure across these complementary inflation hedges and, importantly, simplicity for investors.
Should Allocations and Securities Be Actively Managed?
This “one-third, one-third, one third” benchmark is also a good starting point for actively managing the mix of asset classes, which can be an important tool for enhancing the overall effectiveness of the diversified real asset strategy.
As the drivers of future inflation risk naturally evolve, relative attractiveness across these three real asset classes will change, since they each respond differently to different inflation drivers. A rigorous asset allocation methodology that can identify macroeconomic and sector-specific risks and opportunities may add value for investors by tilting the real asset mix around the static benchmark weights.
In addition, actively managing each of the asset classes vs. their own respective indexes provides a second layer of excess return potential. TIPS, perhaps in contrast to their perception as a staid Treasury asset, allow investors to express a multitude of macro and micro views that can enhance the real return potential of that allocation.
Similarly, commodity index-related investments offer a rich opportunity set, both within the commodities futures exposure and within the underlying cash collateral. Of note are active commodities strategies based on structural aspects of underlying physical and futures markets, which may provide higher risk-adjusted return potential than directional “commodity picking.”
Also, active REIT selection or even passive REIT index exposure collateralized by actively managed cash collateral allow a hands-on manager to potentially enhance returns.
The Time Is Now
Many investors realize that the recipe for investment success in the 1980s and 1990s – stocks (and bonds) for the “long run” – is unlikely to produce comparable return potential going forward. That simple approach will be further challenged if high inflation does in fact materialize.
That’s why we believe investors should look to diversify away from the high equity risk implicit in historical allocations and position for heightened inflation risk over the longer term. In this environment, real assets have become a focus, as has having a single, diversified strategy for managing those collective exposures |
