Second in a series of articles exploring diversifying asset strategies, including fixed income, real assets, capital preservation and equities.
“Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.”
- Ronald Reagan
In 1978, when then-candidate Ronald Reagan likened inflation to a mugger, it struck a nerve. Inflation was running at a 9% annual clip, on its way to nearly 15% two years later. Inflation was a harsh reality.
Today, inflation is tame, and the voices of monetary hawks have been drowned out. Nonetheless, when it comes to investing for retirement, consultants concur: Inflation is one of the greatest risks, and inflation-fighting assets should be part of retirement portfolios.
Although inflation may seem a distant threat, we believe inflation-fighting assets are critical to defined contribution (DC) plan portfolios because inflation often strikes without warning. Moreover, for retirees, who often depend on income that does not adjust with inflation, even relatively tame inflation can be devastating. Consider: After 20 years of 3% annual inflation, $50,000 in retirement income would buy only about $27,000 worth of goods and services; with 5% inflation, the value shrivels to only about $18,000.
This helps explain why 89% of respondents to the 2014 PIMCO DC Consulting Support and Trends Survey support offering an inflation-hedging choice in a DC plan’s core investment menu. Inflation-fighting asset classes can help portfolios in other ways, too: They may diversify risk from traditional stocks and bonds, reduce portfolio volatility and mitigate downside risk.
Consultants favor commodities, TIPS, REITs
For core menus, a majority of consultants we polled suggest the addition of a multi-real-asset blend. The blend may include commodities, Treasury Inflation-Protected Securities (TIPS) and real estate investment trusts (REITs), which consultants view as most valuable in fighting inflation.
Less than half advocate adding discrete inflation-hedging asset classes to core menus. Notably, over a quarter of the consultants (27%) suggest a global tactical asset allocation strategy that combines both real and nominal assets; this strategy might also state an outcome objective or secondary benchmark (e.g., CPI plus 5%).
Figure 1A shows the inflation-fighting asset classes that consultants most favored in core lineups. Figure 1B shows the importance consultants placed on individual inflation-fighting assets within multi-real-asset strategies.
Regrettably, adding inflation-hedging assets to DC menus is a potentially complex challenge, one that requires thoughtful analysis and preparation. For one, individual inflation-fighting assets respond to inflation in different ways. Then, as detailed in “Designing Balanced DC Menus: Considering Diversified Fixed Income Choices” (April 2014), there’s the “1 over n,“ or naïve diversification, problem – i.e., the tendency of DC participants to allocate their assets evenly among fund choices (see Figure 2).
Broadly speaking, we suggest offering a balanced menu of investment choices designed to boost the odds that participants create reasonably balanced portfolios even when blindly allocating equal sums across menu options. Before plan sponsors can responsibly add inflation-fighting assets to core menus or target-date strategies, however, we believe that measures such as inflation beta, equity correlation, volatility and downside risk need to be evaluated (see Figure 3).
Evaluating real asset strategies
Let’s take a look at how inflation-hedging asset classes and blends perform against these measures:
Inflation beta: We believe asset prices are much more sensitive to inflation surprises than actual levels of inflation; i.e., investors react strongly when outcomes differ from expectations. Historically, inflation spikes have occurred quickly and unexpectedly. Therefore, we believe the most important factor for DC participants in selecting a real asset is its sensitivity to inflation surprises. Asset classes with a positive beta to inflation surprises have historically tended to perform well, thus preserving purchasing power, during inflationary market environments.
As Figure 4 shows, the inflation beta of a stock/bond portfolio (composed 70% of the MSCI World and 30% of the BAGG) was -2.07 as of 31 March 2014. By contrast, all of the asset types and blends except for infrastructure showed a higher inflation beta. Commodities, gold and natural resource equities stood out with the highest inflation betas.
- Equity correlation: To reap the potential diversification benefits of real assets, each asset type and blend should be evaluated for its correlation to equities. Viewed through this lens, the stock/bond portfolio shows a tight correlation, 0.95, to the S&P 500, while other assets or combinations show lower correlations (thus offering improved diversification potential). Assets with the lowest correlations include TIPS, gold and commodities.
- Volatility: Selecting an individual asset class or blend with relatively low volatility is important to lessening the risk of participants selling out with a sudden shift in returns. As Figure 4 shows, the stock/bond portfolio had volatility of 12.5%, while other asset types or blends offered smoother rides. Of note, TIPS, bank loans and the expanded multi-real-asset blend showed lower volatility.
- Downside risk: Although there are many ways to measure tail risk, we suggest evaluating risk exposure by assessing Value-at-Risk (VaR) at a 95% confidence level (VaR estimates the minimum expected loss at a desired level of significance over 12 months). Applying this measure, we observe that the stock/bond portfolio has potential downside risk of -19.3%. Other asset types and blends may have less downside risk. TIPS, bank loans and the expanded multi-real-asset blend stand out again.
Summary comparison of individual and multi-real-asset blends
By comparing asset classes across these metrics, Figure 4 underscores that when it comes to fighting inflation, a multi-pronged approach may be best. It lists individual asset types followed by multi-real-asset and expanded multi-real-asset categories. Lower down, the chart shows the performance of a 70% equity and 30% bond allocation, followed by an expanded multi-real-asset blend that shifts 20% of the stock and bond allocation to TIPS, commodities, real estate, emerging markets, currency and gold indexes.
These data go a long way in explaining why the consultants we polled are most supportive of adding multi-real-asset strategies to a DC plan’s core lineup. Relative to the stock/bond portfolio, both the multi-real-asset and expanded multi-real-asset blends offer inflation-hedging (positive inflation betas) and potential diversification benefits (i.e., equity correlations < 1). What’s more, both blends show the potential for lower volatility and less risk of loss (VaR) than the stock/bond portfolio. Notably, the blends may offer volatility and risk-of-loss levels below those of many individual real assets. To simplify a core lineup and reduce the risk that a participant will chase or flee an investment upon enticing or unfortunate returns, these multi-real-asset blends may be preferable to individual assets.
In addition to adding the multi-real-asset blend or the expanded multi-real-asset blend to the core lineup, a plan sponsor should evaluate their investment default for its ability to stand up to inflation. Plan sponsors may want to add these multi-real-asset blends to the investment default glide path or may prefer adding individual asset classes in different weights based on target-date vintage. As Figure 4 shows, shifting 20% of the 70/30 stock-and-bond allocation to the expanded multi-real-asset blend allows the potential inflation-fighting and diversification benefits to shine through. Most notably, volatility decreases from 12.5% to 9.8% while the potential loss (VaR) drops from -19.3% to -14.6% and the inflation beta increases from -2.07 to -1.19.
A balanced approach
Inflation-fighting strategies are fundamental to DC investment lineups and participants’ need to build and preserve purchasing power in retirement. Plan sponsors should evaluate inflation-fighting assets, separately and in combination, to determine how best to offer them.
Whatever choices are made, selected assets or blends should be designed to deliver the primary benefits of inflation responsiveness, diversification relative to stocks, volatility reduction and downside risk mitigation. To deliver these and ward off the inflation robber baron, plan sponsors may find multi-real-asset blends attractive both as core options and as additions to asset allocation strategies such as target-date funds.
In Figure 5, we list the inflation-fighting assets consultants rated “important” along with suggested index proxies. In addition, we show two multi-real-asset blends, as well as a stock and bond portfolio.