Deflating Inflation Redefining the Inflation-Resistant Portfolio
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Deflating Inflation
Redefining the Inflation-Resistant Portfolio
n What assets provide the best n How much and what type of n How to assess the inflationary
defense against inflation? inflation protection should an landscape and when to implement
investor seek? an inflation protection strategy
April 2010
Investment Products Offered
• Are Not FDIC Insured • May Lose Value • Are Not Bank GuaranteedTable of Contents 1 Key Research Conclusions 2 Introduction Inflation Protection…Why Bother? 5 How to Hedge Inflation What Assets Provide the Best Defense? 18 Getting Real Incorporating Inflation Protection in the Portfolio 26 Monitoring the Temperature of Inflation When to Implement a Protection Strategy 30 Appendix Further Details on How Different Assets Respond to Inflation
Key Research Conclusions
Most investment portfolios are not designed with inflation risk effectively serve as complements to one’s existing “nominal”
explicitly in mind. As a result, many investors are often danger- asset allocation—provides the most efficient means of
ously susceptible to an unexpected rise in inflation, which can hedging against inflation risk without detracting from the
present one of the most pernicious environments for traditional portfolio’s other goals.
portfolios. What’s worse, at the same time that many investors’
assets are hit by an inflationary spike, their liabilities or living n Finally, because each investor’s liabilities and portfolio
costs tend to rise. Such a double whammy can leave investors in objectives are different, there is no single inflation protection
a deep hole. formula that is “right” for all investors. The key factors
driving the appropriate amount and type of inflation protec-
There’s a good deal of confusion and disagreement about how tion are the investor’s risk tolerance and overall vulnerability
best to protect against inflation, both in terms of what assets to adverse inflation surprises.
hedge inflation most effectively and how to incorporate them
in a portfolio. This paper provides a framework for analyzing Incorporating inflation protection will likely cost a little bit over
the inflation-hedging decision. Our research shows that: time (in terms of forgone returns), but in the event of an
unexpected inflationary shock, it should provide valuable
n While many different assets could potentially hedge against protection by reducing the large loss in purchasing power that a
inflation, their effectiveness varies, as do their reliability and traditional stock/bond mix is likely
their cost-effectiveness. to suffer. n
n Arbitrarily incorporating inflation hedges could markedly shift
the otherwise carefully constructed risk/return profile of a
portfolio. We found that a suite of real investments—which
Deflating Inflation: Redefining the Inflation-Resistant Portfolio 1Introduction
Inflation Protection…Why Bother?
Philosopher and poet George Santayana famously remarked, Display 1
“Those who cannot remember the past are condemned to repeat
Inflation Spikes Decimate Traditional Stock/Bond Portfolios
it.” While he almost certainly didn’t have inflation in mind when
Inflation and Negative 60/40 Real Returns
he made this assertion, investors should find the aphorism no less Rolling 10-Year Annualized
relevant. Indeed, although inflation shocks haven’t been a
WWI Spike WWII Spike 1970s Spike
dominant feature of the developed world landscape in nearly a
generation, the historical record warns us that when they have 10
struck, they’ve done so with terrible force, leaving ruined invest-
ment portfolios in their wake. Put simply, the history of inflationary
episodes is a past that no investor should hope to repeat. 5
Percent
The recurring pattern in Display 1 gauges the devastation
wrought by such episodes. The circled blue bars indicate all
0
the 10-year periods in the US from 1900 to the present when
a hypothetical well-diversified portfolio—comprising 60% stocks
(represented by the S&P 500) and 40% bonds (represented by
–5 Deflation
10-year Treasuries)—generated negative inflation-adjusted (or
“real”) returns. The green bars represent rolling 10-year 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
annualized rates of inflation, and the shaded gray areas at the Inflation Negative 10-Year 60/40 Real Returns
top designate inflation spikes—periods when there was a three- This is a hypothetical example and is not representative of any AllianceBernstein
percentage-point increase (or more) in the rate of inflation over product. Individuals cannot invest directly in an index.
the prior 10 years. The spikes in inflation coincide with the The portfolio comprises 60% stocks and 40% bonds; stocks are represented by the S&P
500 (with a Global Financial Data extension) and bonds by 10-year Treasuries.
decade-long collapses in real portfolio performance. Inflation is measured by US CPI, US City Average, all items, not seasonally adjusted.
Source: Global Financial Data (GFD), US Bureau of Labor Statistics (BLS), and
AllianceBernstein
Perhaps surprisingly, even during the Great Depression (the
highlighted deflationary era during the 1930s), investors fared
better at generating positive inflation-adjusted returns than they What’s more, the compounding effect of negative real returns,
did during periods of escalating inflation. To be sure, portfolio coupled with the fact that many investors need to tap their
values plummeted during the Depression, but so did prices for portfolios to support their spending (which itself is typically linked
almost everything else, leaving the real purchasing power of a to inflation), can cause a massive loss in portfolio purchasing
traditional 60/40 portfolio (as defined above) relatively intact. By power over time. For example, in the US by the early 1980s—
contrast, during the three inflationary periods over the last 100 when the 10-year rate of inflation reached 9%—a 60/40 portfolio
years, the real value of a diversified portfolio dropped sharply. would have experienced a real return of –3.5% on an annualized
2 AllianceBernstein.comDisplay 2
Inflation Causes Massive Decline in Real Portfolio Value
US UK Japan
1972–1982 1910–1920 1946–1956
10-Year Inflation Rate* 9% 11% 23%
60/40 Stock/Bond Real Return* –3.5% –9.3% 3.3%
Decline in Real Portfolio Value (After Spending) –65% –86% –52%
This is a hypothetical example and is not representative of any AllianceBernstein product. Individuals cannot invest directly in an index.
*Annualized
Assumes 60/40 stock/bond allocation, with 4% annual spending rate on initial portfolio value (spending grown with inflation). Inflation is represented by the respective inflation
indices of the US, the UK, and Japan. Stocks in the US are represented by the S&P 500 Index; in the UK, by the FTSE All-Share Index; and in Japan, by the Nikko Securities
Composite. Bonds are represented by the 10-year government bond indices of the US, the UK, and Japan, respectively.
Source: BLS, GFD, and AllianceBernstein
basis (Display 2). Add in a typical spending rate of 4% a year from It’s important to note that while many different assets could
the portfolio, and almost two-thirds of an investor’s real wealth potentially provide some protection against inflation, their ability
would have vanished by the end of the decade. to do so varies, as do their reliability and their prospective cost,
particularly when measured in terms of the expected returns
In Britain in the decade surrounding World War I, the same rate they provide compared with what they’re replacing in the
of spending, combined with inflation at 11%, resulted in even portfolio. Also, arbitrarily incorporating one or more of these
worse portfolio performance: Nearly 90% of the investor’s real assets could markedly shift the otherwise carefully constructed
wealth would have been eaten away. The post–World War II risk profile of any portfolio. Finally, because investors’ liabilities,
story in Japan is similar: Even modestly positive portfolio real risk tolerance, and portfolio objectives differ, there’s little reason
returns failed to overcome the extreme rates of inflation to believe that a “one size fits all” inflation protection formula
endured during the early years of that decade, and real portfolio could be devised that would be “right” for every single investor.
value declined by more than half. Simply put, traditional
stock/bond portfolios do not adequately defend against the Our goal here is to clear up some of the confusion surrounding
calamity of adverse inflation surprises and can leave investors in these issues. We aim to provide insight into the tools available
a deep hole. to protect against inflation risk and how an inflation-hedging
strategy might be best implemented in light of one’s broader
The Current Inflation Fixation investment objectives.
The debate about the direction of future inflation and the
damage it can cause a portfolio has become increasingly Incorporating An Inflation Hedge in the Portfolio
fraught of late. The massive fiscal and monetary expansions de- One of the key insights emerging from our research is that it is
ployed in response to the global financial crisis have prompted possible to build an effective suite of inflation hedges that can
many investors to think about how vulnerable they are to an fit seamlessly into a traditional portfolio, without causing undue
inflation shock and how to protect their portfolios. Many have distortion to its prior risk profile. Because many investors already
rushed headlong into assets generally considered to be strong frame the essential building blocks of their asset allocation
inflation antidotes, such as gold and inflation-protected bonds. construction in terms of cash, bonds, and stocks, a parallel
Unfortunately, however, there’s little consensus and much complement of inflation hedges makes holistic portfolio sense.
confusion about how best to protect against inflation risk. In other words, we believe the same goals of any traditional
Deflating Inflation: Redefining the Inflation-Resistant Portfolio 3Display 3 commodity futures, and foreign currency exposure).1 This
Real Investments Complement Traditional Counterparts approach can readily be tailored to an investor’s existing risk
appetite by simply introducing the appropriate amount of
“Traditional” vs. Inflation-Protected Allocation
inflation-protecting or “real” equivalents into the existing
100
“traditional” allocation. But as we will detail in this study, since
each of these hedges has distinctive virtues and shortcomings,
80 Commodities, most investors will want to fine-tune their inflation-hedging
Diversified Diversified Real Real Estate, FX,
Stocks Stocks Assets Commodity-Related strategy to reflect their own unique needs.
60 Equity Investments
Percent
The second major conclusion stemming from our research is that
40 adding inflation protection to a traditional asset allocation is
unlikely to improve expected returns. Inflation protection does
Diversified Diversified Real Intermediate-Term
Bonds Bonds Bonds Inflation-Linked Bonds have a cost in terms of forgone returns. But, the protection it is
20
designed to provide—reducing the loss in purchasing power that
Short-Term
Cash Cash Real Cash a traditional stock/bond mix would likely suffer—is valuable
0 Inflation-Linked Bonds
Traditional Inflation-Protected should an inflationary shock occur.
Allocation Allocation
For illustrative purposes only With this “hedging” perspective in mind, we detail in the
Source: AllianceBernstein following pages a framework whereby investors can:
allocation (in terms of balancing its risk and return objectives) n Assess which financial assets may most effectively protect
can be achieved in a corresponding inflation-protected alloca- against inflation, either alone or in combination;
tion (Display 3).
n Determine the type and amount of inflation protection
We categorize these inflation hedges in three broad buckets: needed, as well as the least intrusive way to embed it in the
Real Cash, Real Bonds, and Real Assets. Lower-volatility Real portfolio; and
Cash and Real Bond portfolios are represented by short-term
and longer-term inflation-linked bonds, respectively, while Real n Evaluate the current inflationary landscape and determine
Asset portfolios encompass a variety of higher-risk inflation when might be the right time to implement an inflation
hedges (including real estate, commodity-related stocks, protection strategy. n
Chapter Highlights
n Most investors need some form of inflation protection; the proper type and amount depend on their circumstances.
n While inflation hedges will cost a little in performance on average, they will help protect the portfolio against the
devastation that inflation can bring.
1Note that the Real Assets category is also appropriate for investors with allocations to certain “alternative” investments. We see some illiquid real investments (such as direct real
estate) as viable substitutes for liquid real investments (such as REITs) for investors willing to assume liquidity risk.
4 AllianceBernstein.comHow to Hedge Inflation
What Assets Provide the Best Defense?
It’s not an easy matter to determine which assets provide the else equal, the higher an asset’s inflation beta, the stronger its
best defense against inflation. In part, this is because long-term appeal as an inflation hedge. But in addition to its beta, we
performance records across different inflationary cycles do not need to consider the reliability of any prospective hedge, since
exist for many asset classes.2 We’ve been able to overcome having a high inflation beta is of limited value if the protective
some of these limitations by building our own, proprietary benefit works only some of the time. Finally, inflation hedges
historical data series for commodity returns, and by construct- come with a cost (measured primarily by the expected return
ing a hypothetical return series for inflation-linked bonds sacrifice relative to a traditional investment with similar volatili-
stretching back more than a century (see sidebars on pages 8 ty). Minimizing that cost should be part of any sensible inflation-
and 14). But even apart from the dearth of data available in hedging strategy.
conventional investment databases, we should expect most
inflation hedges to vary significantly in their effectiveness across Inflation Sensitivity
time and across different inflationary episodes. Therefore, to There are generally two opposing forces that drive an asset’s
build an effective portfolio of inflation hedges, it’s critical to sensitivity to inflation, or inflation beta. On one hand, inflation
understand the key drivers of each asset and its fundamental can have a positive impact on an asset’s value when rising prices
response to changes in inflation. also result in rising cash flows (Display 4, left, following page).
For example, the revenues of many commodity-related compa-
We identified three key factors that help us determine the nies “pass through” inflation relatively efficiently. To the extent
effectiveness of any prospective inflation hedge: the costs such companies face react less strongly to an inflation
surprise, they should be able to pass those rising prices through
n Its sensitivity to inflation to the bottom line.
n Its reliability as a hedge But rising inflation also damages asset values because it is a
proxy for rising inflation expectations, a key driver of the
n Its cost-effectiveness discount rate used to gauge the present value of future cash
flows. Higher discount rates cause the market to devalue an
We measure an asset’s inflation sensitivity by quantifying the asset, because future cash flows are worth less in today’s money
average impact of an increase in the inflation rate on the asset’s (Display 4, right, following page). The further out in time any
total return. We call this measure an asset’s “inflation beta.” All fixed cash flows extend, the greater the asset’s sensitivity to
2For example, inflation-linked bonds are a recent innovation. In the US, Treasury Inflation-Protected Securities, or TIPS, were first offered in the late 1990s; inflation-indexed
“Linkers” in the UK date back to the early 1980s.
Deflating Inflation: Redefining the Inflation-Resistant Portfolio 5Display 4 Display 5
Rising Inflation Has a Dual Impact on Asset Returns Inflation Sensitivity Varies by Asset Class
Asset Class Inflation Betas
Positive Return 1965–2009
Impact 6.5
Cash Flow
Rise 1.7
Discount Rate 0.8
0.3
Rise
Negative Return –2.4
–3.1
Impact
20-Yr. S&P 500 3-Mo. T-Bills 10-Yr. TIPS* Farmland† Commodity
For illustrative purposes only US Treasuries Futures‡
Source: AllianceBernstein
Historical analysis is not a guarantee of future results. Individuals cannot invest directly
in an index.Total return beta to one-year inflation rate change in multivariate regression
including lagged inflation rate.
discount rate fluctuations. It’s the net impact of these two *10-year Treasury Inflation-Protected Securities (TIPS) are calculated from synthetic
phenomena—greater expected cash flows and higher discount AllianceBernstein real yields estimated from actual inflation and nominal yield curve
variables before 1999 and from Federal Reserve real yields thereafter.
rates—that determines an asset’s behavior in an environment of †Farmland is the national average value per acre as determined by the US Department
rising inflation. of Agriculture (USDA).
‡Commodity futures prior to 1990 are on a US consumption–weighted basis and are
sourced from AllianceBernstein series prior to 1970 and from the MJK Commodity
Inflation sensitivity across a range of assets can vary signifi- Futures Database between 1970 and 1990; they are represented by the Dow Jones-
cantly (Display 5).3 In the US, for example, for a given 1% UBS Commodity Futures Index (DJ-UBS) thereafter. All futures returns are fully
collateralized by T-bills unless otherwise indicated.
increase in the inflation rate, 20-year nominal bonds fell 3.1 Source: DJ-UBS, Federal Reserve, GFD, London Times, MJK Associates, The
times as much. Stocks, too, tend to be vulnerable to most New York Times, USDA, The Wall Street Journal, and AllianceBernstein
rising inflation environments: On average, the S&P 500
historically dropped 2.4 times the rise in inflation, and the Taking Stock of Equities in Inflation
broad equity indices of many other countries showed a similar Stocks are often considered a relatively robust inflation hedge.
sensitivity. This helps explain the dismal performance we saw But while it’s true that diversified equities can overcome
in the traditional 60% stock/40% bond portfolio during inflation over very long horizons, their record as a hedge against
periods of accelerating inflation. There are some assets, accelerating inflation over the short to medium term is poor.
however, that have tended to post positive returns in a rising This comes as a surprise to many investors, who correctly point
inflation environment, including T-bills, inflation-linked bonds, out that as long as a company’s expenses (the largest compo-
certain types of real estate, and commodities. But first let’s nent of which are usually “sticky” wages) don’t increase at the
explore equities a bit further, to see just what’s driving these same pace as its revenues, the wider profit margin will translate
returns. (For more information on how various assets may into greater cash flows. In fact, S&P 500 data show that equity
react to accelerating inflation rates, see the Appendix, pages earnings do tend to grow faster—more than 6% faster than
30–35.) average—in years when inflation accelerates (Display 6, left).
3Given the availability of data for multiple asset classes and the ability to confirm our conclusions across many different countries, we show results from 1965 to the present in many
of the displays that follow. Our longer-term US data were then used to corroborate these indications where applicable.
6 AllianceBernstein.comSo companies will see higher cash flows in such an inflationary Seeking High Inflation Betas Across an Array of Assets
environment, but the market will generally apply a higher Nominal bonds also perform poorly in rising inflation environ-
discount rate to those cash flows. Which effect dominates ments: Their future cash flows are fixed, so a rising discount rate
valuations: higher expected cash flows or the higher discount (due to higher expected inflation) damages the current value of
rate? According to the long-term history of the S&P 500 in the the bond. In general, the longer the bond’s maturity, all else equal,
US, in years when inflation accelerated, price/earnings multiples the more vulnerable it will be to changes in inflation expectations.
tended to drop, on average, by 1.4 points (Display 6, right). Short-maturity bills perform better than their longer-maturity
However, there are exceptions to this. For example, in extremely counterparts during rising inflation, because the yields of new bills
low or negative inflationary environments, an increase in will discount higher inflation expectations when inflation spikes. In
inflation expectations tends to coincide with an increase in other words, the shorter the maturity of nominal bonds, notes,
equity prices, resulting in positive inflation betas. This anomaly and bills, the more quickly investors are able to reinvest in new
occurs because as inflation moves from abnormally low levels instruments that reflect any changes in inflation expectations.
back toward more normal levels, general economic uncertainty
falls—and, with it, risk premia of all types. Inflation-linked bonds (“ILBs” for short), such as US TIPS and UK
“Linkers,” are designed to simply pass through changes in
But most of the time, and for most stocks, the ability of consumer or retail price indices, CPI and RPI, respectively. As
companies to pass through price increases is more than offset measured by our synthetic series, ILBs would have delivered
by the negative influence of higher discount rates—which is inflation betas of nearly 1.0 over time. The reason we estimate
why diversified equity indices in nearly every country we studied the beta for ILBs at generally slightly below 1.0 is because a rise
have a negative inflation beta. That said, some equity sectors, in inflation sometimes dovetails with a rise in real interest rates,
such as natural resources and real estate, have historically which damages the value of a fixed income investment.4 Our
exhibited less-negative (or even positive) inflation betas than research suggests that this was the case in the US during the
diversified stocks. What these sectors tend to have in common late 1970s and early 1980s, a time of both heightened concern
is high capital intensity: They have such high fixed costs that over the country’s monetary stability and, in response, tighten-
when inflation accelerates, margin expansion often overwhelms ing central bank policy. We estimate that during this period, the
the opposing discount rate impact. fall in the price of inflation-linked bonds due to higher real
Display 6
Rising Inflation Leads to Higher Earnings… …but a Higher Discount Rate Hurts Valuations
S&P 500 Earnings per Share Growth vs. Average S&P 500 Price/Earnings Change
6.2% 2.5×
–5.9% –1.4×
Decelerating Accelerating Decelerating Accelerating
Inflation Years Inflation Years Inflation Years Inflation Years
Historical analysis is not a guarantee of future results. Individuals cannot invest directly in an index.
Average year-over-year growth, 1930–2008
Source: Robert J. Shiller, Irrational Exuberance, Princeton University Press, 2000; and AllianceBernstein
4Also, inflation-linked bonds in most countries have a short contractual lag in passing through actual inflation, which could further weaken the measured inflation beta.
Deflating Inflation: Redefining the Inflation-Resistant Portfolio 7Re-Creating the History of Inflation-Linked Bonds
Although inflation-linked bonds (ILBs) form a crucial The key to creating a synthetic ILB series is to understand
component of most inflation protection strategies, the how inflation expectations are formed. Nominal government
historical record necessary to judge how ILBs may behave in bond yields can be decomposed into a real yield, expected
disparate economic environments does not exist. The United inflation, and an inflation risk premium earned for bearing
Kingdom was the first to issue such bonds—called Linkers— the uncertainty around whether actual inflation will meet
in the early 1980s, followed by Sweden, Canada, and expectations. If inflation expectations are known, then the
Australia; eventually the US issued Treasury Inflation- real yields that ILBs offer can be estimated by subtracting
Protected Securities—TIPS—in the late 1990s. Because inflation expectations and the estimated inflation risk
inflation has been comparatively stable during this relatively premium from nominal yields. Fortunately, because inflation
brief period, we decided to construct a synthetic ILB return expectations are a function of historical experience—like
series extending back to the 1890s* to gain better perspec- most expectations, they are largely backward-looking—they
tive on how these instruments might have performed in can be reliably estimated historically.
different inflationary environments.
US Inflation Expectations UK Real Yields
US Model Estimates of Survey Inflation Forecasts US Model Estimates of UK Real Yields
One-Year US CPI Forecasts 10-Year Linker Yields
12 5
4
9 Actual
Estimated Real Yield
Forecast 3
Percent
Percent
6
2
Actual Estimated
3 Forecast Real Yield
1
0 0
1970 1980 1990 2000 2010 1989 1994 1999 2004 2009
Historical analysis is not a guarantee of future results. Estimate based on actual US Historical analysis is not a guarantee of future results. Estimate based on actual
inflation and yield curve variables. UK inflation and yield curve variables.
Source: Federal Reserve and AllianceBernstein Source: Bank of England, Federal Reserve, and AllianceBernstein
*Due to the paucity of reliable long-term non–US capital markets data, our analysis throughout takes a largely US investor perspective. Where possible, we have
conducted analyses from different country perspectives. The conclusions herein should be relevant to most countries around the globe.
8 AllianceBernstein.cominterest rates would likely have offset some of the positive
benefits of the contractual inflation accrual, thereby diminishing
returns. The relationship between inflation and real yields is
The display on the left of the facing page shows how therefore a key question in determining the efficacy of inflation-
accurately one-year consensus inflation expectations can be protected bonds as an inflation hedge. Although inflation-
estimated with nothing but backward-looking knowledge of protected bonds could produce negative returns in the event of
actual inflation. The blue line shows surveyed consensus a large spike in both real yields and inflation, they would still
expectations, while the green line shows an estimate of outperform traditional bonds, which would do even worse. (For
expectations based on weightings to various measures of more on inflation-linked bonds, see the Appendix, pages 31–32.)
actual trailing inflation. Because actual inflation data can be
sourced going back to the 1800s, we can estimate where Some investments—what we term “real assets”—have
expectations likely were at any point in time, and, with that, empirical and expected inflation betas greater than 1.0. For
where real yields were.† To gauge the validity of this example, some real estate assets throw off cash flows tightly
approach, we applied our US-based weightings to UK data linked to inflation and so tend to have high inflation betas.5 The
and compared the resulting estimates of UK real yields to cash-flow sensitivity of real estate stems from both the propor-
actual UK real yields, as shown in the display on the right of tion of value tied up in land (i.e., the proportion of costs that
the facing page. The close fit suggested that our synthetic are fixed) and the sensitivity of “rents” to inflation. Generally
real yield series was robust enough to calculate ILB returns speaking, the higher the proportion of land in a real estate
for implementation in our asset allocation work. asset’s value, the higher its inflation beta. And for most types of
residential and commercial properties, rents take the form of
In addition, using this much longer, synthetically con- fixed lease payments—so in general, the shorter the lease term,
structed time series of inflation expectations, we were able the greater the inflation sensitivity. Agricultural properties such
to explore a number of long-unsolved investment ques- as farmland also serve as good inflation hedges because their
tions—such as whether expectations drive actual inflation. “rents” (in the form of farm product and timber prices) vary
We found that the impact of inflation expectations on directly with inflation-sensitive agricultural commodity prices.
actual inflation likely varied with the level of inflation.
Anecdotal evidence from Japan suggests that consumers The investment that ranks best by far in terms of inflation beta is
put off purchases when there are expectations of future commodity futures. A broadly diversified basket of commodity
deflation, resulting in a weaker economy and a self- futures exhibited an inflation beta of 6.5 from 1965 to the
fulfilling prophecy of more deflation. Our research on US present. (This is from a US investor’s point of view; it would differ
inflation indicates that in high-inflation environments (CPI from the perspective of investors in other countries. See the
greater than 5%), the pass-through of inflation expecta- Appendix, pages 33–34, for more information.) That’s because
tions to actual inflation is twice as large as it is in low- commodity futures returns tend to embed a high sensitivity to
inflation environments (CPI between 0% and 5%). n shorter-term supply-and-demand economics. An overheating
economy often goes hand in hand with both rising inflation and
price and inventory pressures in the commodities markets,
leading to higher futures returns. Some have taken this idea
†A structural break in how inflation expectations in the US were set occurred
between World War II and the 1970s with the transition away from a gold further, suggesting that commodities may well be the preferred
standard. Including various nominal yield curve variables allowed us to adjust for
this break and extend our series back to the gold standard era.
5In our real estate research, we relied on the NAREIT Equity REIT Index since 1971 and a REIT proxy prior to that time comprising non-REIT real estate stocks and a
building cost index. The current global public real estate equity market is composed of roughly half REITs and half non-REIT real estate companies.
Deflating Inflation: Redefining the Inflation-Resistant Portfolio 9“all-weather” inflation hedge. However, the performance of Clearly, there appears to be a trade-off: the greater the inflation
commodity futures can be unreliable, and their opportunity costs sensitivity, the lower the reliability. What drives this uncertainty?
can be high. Why does reliability tend to be lower for higher-volatility assets,
and can we do anything about it?
The Reliability of Inflation-Hedging Assets
While an inflation beta provides some indication of the direction The Role of Risk (and Return) for Real Assets
and magnitude of an asset’s historical inflation sensitivity, it does One reason that Real Asset inflation hedges aren’t always reliable
not capture the consistency of the inflation hedge. Display 7 shows is that many factors beyond changes in inflation expectations
the percent of rising inflation years since 1965 when various drive their returns. Predicting these factors can be difficult, and
categories of inflation-hedging assets posted positive returns. We this inherent uncertainty is reflected in an asset’s level of
estimate that Real Cash (short-maturity ILBs) and Real Bonds volatility. While higher volatility can enhance inflation beta
(longer-maturity ILBs) provide the greatest stability: Even though (assuming a positive relationship between asset returns and
their inflation sensitivity was lower, it was very reliable. A diversified inflation surprises), it tends to reduce the reliability of the hedge.
basket of hedges from the equity sector—a category that includes
both real estate and commodity-related stocks—was less reliable, Display 8 shows the trade-off between inflation beta and risk-
but still delivered positive returns during periods of rising inflation adjusted returns. REITs and several commodity-related equity
over three-fourths of the time. Then there’s the highest-inflation sectors (energy, agriculture, and metals stocks) occupy the upper
beta groups, such as commodity and precious metals futures, left of the display, indicating that historically they have provided
which had reliability akin to a coin flip—when they worked, they better risk-adjusted returns, but with small and sometimes even
worked exceptionally well, but they failed nearly as often.
Display 8
Display 7 Real Assets: The Trade-Off Between Inflation Sensitivity and
The Reliability of Inflation Hedges Varies Volatility-Adjusted Returns
Percent of Rising Inflation Years with Positive Returns Inflation Betas vs. Volatility-Adjusted Returns
1965–2009 1965–2009
96% 0.8
84% 76% 76% S&P
54% 49% 500 REITs
0.6 Energy Stocks
Return/Volatility
Agriculture Stocks
Industrial Metals Gold
One-Yr. 10-Yr. Commodity REITs Commodity Precious 0.4 Industrial Metals Stocks Futures Bullion
TIPS TIPS Stocks Futures Metals Short- Intermed- Commodity Real Commodity Precious
Livestock Futures Softs
Futures term iate-Term Stocks Estate Futures*Gold
Metals
Stocks
TIPS 0.2
TIPS Stocks Futures Futures
Real Cash Real Bonds Real Assets
Grain Futures Precious
Metals
Historical analysis is not a guarantee of future results. Individuals cannot invest directly in Futures
an index. TIPS are calculated from synthetic AllianceBernstein real yields estimated from 0.0
actual inflation and nominal yield curve variables before 1999, and they are sourced –3 –1 1 3 5 7 9
from Federal Reserve real yields thereafter; commodity stocks and precious metals futures
are sourced from the Ken French Data Library; and REITs are represented by the Inflation Beta
NAREIT Index. Commodity futures prior to 1990 are on a US consumption–
Historical analysis is not a guarantee of future results. Individuals cannot invest directly in
weighted basis and are sourced from the AllianceBernstein series prior to 1970 and from
an index. Commodity futures prior to 1990 are on a US consumption–weighted basis and
the MJK Commodity Futures Database between 1970 and 1990; they are represented
are sourced from the AllianceBernstein series prior to 1970 and from the MJK Commodity
by DJ-UBS thereafter. Commodity futures and precious metals futures are fully
Futures Database between 1970 and 1990; they are represented by DJ-UBS thereafter.
collateralized by three-month T-bills.
Commodity-related stocks and futures are sourced from the Ken French Data Library; gold
Source: BLS, Commodity Research Bureau (CRB), DJ-UBS, Federal Reserve,
bullion is represented by London FX, and REITs by the NAREIT Index.
Ken French, GFD, International Monetary Fund (IMF), London Times, MJK
Source: BLS, Ken French, GFD, London FX, London Times, NAREIT, The
Associates, NAREIT, National Bureau of Economic Research (NBER), The New
New York Times, The Wall Street Journal, and AllianceBernstein
York Times, USDA, US Geological Survey (USGS), The Wall Street Journal,
and AllianceBernstein
10 AllianceBernstein.comDisplay 9
Blending Real Assets Improves Risk-Adjusted Returns…but the Best Mix of Real Assets Depends on the Desired Inflation Beta
Inflation Betas vs. Volatility-Adjusted Returns Return/Volatility Maximizing Portfolios
1965–2009 1965–2009
1.0 Return/Volatility 100
Commodity Maximizing
0.8 Stocks Portfolios 80
Commodity
Return/Volatility
Allocation (%)
Commodity
Stocks Futures
0.6 60
Commodity Gold
0.4 REITs Futures Bullion 40
0.2 20 REITs
Gold Bullion
0.0 0
–2 0 2 4 6 8 10 –2 0 2 4 6
Inflation Beta Portfolio Inflation Beta
Sectors Asset Classes Portfolios
Historical analysis is not a guarantee of future results. The blending of real assets does not eliminate the risk of loss in a portfolio. Commodity futures prior to 1990 are on a
US consumption–weighted basis and are sourced from the AllianceBernstein series prior to 1970 and from the MJK Commodity Futures Database between 1970 and 1990; they are
represented by DJ-UBS thereafter. Commodity-related stocks and futures are sourced from the Ken French Data Library. Gold bullion is represented by London FX, and REITs by
the NAREIT Index.
Source: BLS, Ken French, GFD, London FX, London Times, NAREIT, The New York Times, The Wall Street Journal, and AllianceBernstein
negative inflation betas (though still higher than diversified black line arching above the blue squares represents different
equities). Commodity futures and precious metals, at the lower combinations of the four asset classes that historically maxi-
right, provide a very pronounced response to any increase in the mized the risk-adjusted return for any given inflation beta.
rate of inflation—with historical inflation betas approaching
10—but with a much less attractive risk/return profile. In short, The chart on the right in Display 9 shows the mix of assets that
for assets with higher inflation betas, you have to pay a higher underlie that black line. Going with REITs exclusively would have
cost (in the form of lower risk-adjusted returns). delivered a high risk-adjusted return at the expense of providing
a slightly negative inflation beta. Conversely, during this period,
Fortunately, the risk-adjusted return for any desired inflation gold would have maximized the inflation beta but would have
beta can be improved by combining various real assets. Our led an investor to suffer rather poor risk-adjusted returns. The
research shows that by judiciously blending these higher- highlighted segments represent the range of allocations that
volatility assets in a diversified portfolio of inflation hedges, we cluster around the highest available risk-adjusted return, with an
can moderate the fundamental trade-off and build a Real Asset inflation beta between 2 and 4.
portfolio that has high inflation sensitivity, reliability, and
risk-adjusted returns. The chart on the left in Display 9 replicates Together, these charts show that volatility-adjusted returns for
the previous display but shows the benefit of grouping the real assets were historically maximized—and a respectable
individual hedges into their representative asset classes (the inflation beta achieved—with portfolios falling within the
labeled blue squares), with REITs at one end, gold at the other, highlighted area. Our research therefore suggests that while
and commodity stocks and commodity futures in between.6 The tactical tilts toward a specific real asset may sometimes be
6Commodity stocks are weighted by market capitalization, and commodity futures are weighted by global production, according to the DJ-UBS methodology from 1990 on; prior to
1990, we use US consumption weights. All futures returns are fully collateralized by T-bills unless otherwise indicated.
Deflating Inflation: Redefining the Inflation-Resistant Portfolio 11Display 10 All Inflations Are Not Equal: Global vs. Local Inflation Hedges
Real Asset Reliability Peaks with Greater Diversification For most investors, it’s both natural and sensible to focus on the
path of inflation in one’s home country, as most of us meet the
Real Asset Portfolio
bulk of our spending needs by purchasing goods and services
Positive Return in Rising Inflation Years
1965–2009 domestically. While inflationary events in developed nations are
by and large global phenomena, inflation at home is sometimes a
85
product of local or country-specific factors. Therefore, an asset’s
tendency to be more responsive to a domestic or a global
inflation shock is an important variable that contributes further
uncertainty regarding the performance of inflation hedges.
For example, most commodity prices respond to global supply-
80
Percent
and-demand pressures. It follows that commodity inflation betas
relate almost entirely to changes in global, rather than domestic-
only, inflation.7 When changes in the domestic inflation rate
correlate highly with changes in global inflation, commodities
can be expected to deliver their characteristically high inflation
beta. But to the extent that domestic inflation shocks are not
synchronized with the globe, commodities will perform less well
75
as a hedge against home-country inflation. For a stark example,
–2 –1 0 1 2 3 4 5 6 7 8
a diversified basket of global commodities hedged back to the
Portfolio Inflation Beta local currency would not have provided much of an inflation
hedge to an investor in Zimbabwe (which recently experienced
Historical analysis is not a guarantee of future results. Commodity futures are represented
by AllianceBernstein prior to 1970, by the MJK Commodity Futures Database hyperinflation). Similarly, global real estate equities and com-
between 1970 and 1990, and by DJ-UBS thereafter; commodity-related stocks and modity equities are driven primarily by global inflation and, if
gold bullion by the Ken French Data Library; and REITs by the NAREIT Index.
Source: BLS, Ken French, London Times, NAREIT, The New York Times, fully hedged to domestic currency, can leave a portfolio
The Wall Street Journal, and AllianceBernstein vulnerable to a domestic-only inflation shock.
appropriate, a strategic Real Asset portfolio should include a By contrast, foreign currency is likely to hedge inflation best
well-diversified mix of real estate equities, commodity stocks, when domestic inflation shocks deviate significantly from global
and commodity futures, with, possibly, a small allocation to gold. trends. Currency forwards—the returns of which are implicitly
embedded in unhedged foreign investments via short-term
In addition, a well-diversified Real Asset portfolio substantially interest rates—price in the expected inflation differential
mitigates the compromise between inflation beta and between two countries. If both domestic and foreign inflation
reliability. Display 10 shows the percentage of rising inflation jump by the same amount, then the forward price should not
years since 1965 when the optimal real asset combinations be expected to move. But if domestic inflation surprises by more
posted positive returns. Reliability peaks with precisely the than foreign inflation, then—all else equal—the domestic
portfolios containing the most balanced blend of real assets, currency will tend to weaken to maintain the relative purchasing
with almost 85% reliability—a degree of reliability similar to power of the currencies. This weakening provides investors with
that of a Real Bond portfolio. positive returns to foreign currency exposure, thus serving as a
hedge against domestic inflation spikes.
7This assumes commodity futures exposures are hedged into domestic currency to separate asset returns from returns associated with foreign currency exposure.
12 AllianceBernstein.comThe best way to address the uncertainty around inflation betas As we saw in the previous section, most investments with higher
created by an asset’s sensitivity to global versus domestic-only inflation betas also have lower risk-adjusted returns. While a
inflation is to incorporate additional exposures in the mix. diversified Real Asset portfolio of higher-risk, inflation-sensitive
Maintaining some foreign currency exposure in a Real Asset assets can improve this trade-off relative to any single inflation
portfolio and collateralizing the commodity futures positions hedge, investors should still expect a Real Asset portfolio to forfeit
with domestic bills or, where feasible, inflation-linked bonds risk-adjusted return relative to a similarly volatile portfolio of
may help balance the inflation exposures of the portfolio, diversified equities.
bolstering the reliability of its inflation beta.
One way to dimension the cost of insuring against inflation is to
Factoring In the Cost of Inflation Protection compare the historical reduction in returns an investor would
Like most hedges, inflation protection does not come free of have experienced between owning “traditional” versus “real”
charge. Although our three buckets of inflation-hedging investments. Display 11 shows the relative performance of the
assets contain no greater direct costs than any traditional (continued on page 16)
portfolio—they all consist of liquid, investable assets or
investment services—they do have an implicit cost: forgone Display 11
return potential.
Inflation Protection Suite Has Cost and Deflationary Downside
Relative Return of Real Investment vs. Nominal Counterpart
In the fixed income space, for example, the expected return 1909–2009
give-up for inflation-linked bonds relative to their nominal
counterparts can be substantial. First, because inflation- 10
protected returns inherently have less risk, nominal bonds
should offer a risk premium to attract investors. But because 5
inflation-linked bonds are less liquid than their nominal
Percent
0
counterparts, ILBs need to offer investors a liquidity premium.
We estimate the net cost of the inflation risk premium of
–5
nominal bonds after adjusting for the liquidity premium on ILBs
to be between 25 and 50 basis points over the long run. And in –10
the context of bond returns, that is a meaningful sacrifice. Rising Inflation Normal Deflation
Real Cash Real Bonds Real Assets
Further, since most tax-exempt investors will source their ILB
allocation from their existing diversified bond portfolios rather Historical analysis is not a guarantee of future results. Rising Inflation references
10-year periods when inflation was 3% (or more) higher than the prior 10 years;
than from a pure government bond portfolio, an allocation to Deflation includes the 10-year periods with price declines; and Normal includes all other
pure government-issued ILBs would entail the forfeiture of the periods. Real Cash represents the relative return of AllianceBernstein one-year synthetic
TIPS versus T-bills; Real Bonds represents the relative return of AllianceBernstein
additional returns and diversification benefits offered by non-
five-year synthetic TIPS versus five-year Treasuries; and Real Assets represents the
government securities. The inflation protection offered by pure relative return of a real asset portfolio (comprising one-third US commodity stocks,
government ILBs is therefore quite expensive for most inves- one-third US REITs, and one-third commodity futures fully collateralized by 10-year
TIPS) versus the S&P 500. (All futures are US consumption–weighted; commodity
tors. However, a Real Bond portfolio that blends the character- stocks are market capitalization–weighted.) Commodity futures prior to 1990 are
istics of ILBs and multi-sector bonds can greatly reduce this sourced from the AllianceBernstein series prior to 1970 and from the MJK
Commodity Futures Database between 1970 and 1990; they are represented by
opportunity cost.8 DJ-UBS thereafter.
Source: BLS, CRB, Ken French, GFD, London Times, The New York Times,
USDA, The Wall Street Journal, and AllianceBernstein
8Another, less efficient alternative would be to alter the characteristics of the investor’s remaining investment in nominal fixed income assets to compensate for the increased exposure to
the government sector coming from ILBs.
Deflating Inflation: Redefining the Inflation-Resistant Portfolio 13Back to the Futures: A Long-Term History of Commodity Returns
The long-cycle nature of commodity fundamentals com- appreciate in line with broad inflation measures, as shown in
bined with the short history of commodity futures prices the display to the left below. Futures returns, however,
makes empirical analysis of these instruments difficult. incorporate an additional source of risk and return in the
Published commodity futures data go back to the 1970s, form of “roll return”: the difference between the spot price
and since that time we have witnessed only two major and futures price of a commodity at any point in time. This
commodity cycles, one global inflation cycle, and no global roll return turns out to be a major driver of commodity
deflation cycles. Basing strategic allocation decisions on such futures returns. As demonstrated in the display to the right
limited history struck us as imprudent, so we built a below, commodity futures with higher roll return (like
proprietary database of US and UK commodity futures gasoline) also have higher futures returns.
returns and commodity inventories* extending back to the
1890s. What we found reaffirmed some of the positive For a US consumption-weighted basket of commodity
attributes of commodity futures but also suggested caution futures, roll return contributed 2% per year to returns from
in extrapolating historical commodity performance. 1900 through 2009, according to our estimates. The spot
and roll returns for commodities also responded well to the
Published spot commodity prices date back at least to the World War I and World War II inflation cycles, just as they
1800s and confirm that on average, commodity prices did in the 1970s cycle. (See the Appendix, pages 33–35,
for more information.) These positive findings, however,
Spot Commodity Returns Have Been In Line with Inflation were counterbalanced by some cautionary notes: Com-
modities can cease trading or their value may be manipu-
Real Spot Returns (Annualized)
lated by government interference.
1900–2009
2
Roll Return Tends to Drive Futures Returns
1 Futures Excess Returns vs. Roll Return (Annualized)
1900–2009†
Percent
0 20
Average: –2 b.p. Gasoline
–1
Futures Returns (%)
10
–2
0
Aluminum
Platinum
Copper
Cotton
Wheat
Coffee
Nickel
Crude
Sugar
Silver
Corn
Gold
Lead
Oats
Coal
Zinc
Eggs
Tin
–10
Historical analysis is not a guarantee of future results. Agricultural commodities are –20 –10 0 10 20
sourced from CRB, IMF, NBER, and USDA; energy by CRB, Energy
Information Administration (EIA), IMF, and NBER; and metals by CRB, IMF, Roll Return (%)
NBER, and USGS.
Source: BLS, CRB, DJ-UBS, EIA, Federal Reserve (Philadelphia and St. †Or life of contract
Louis), IMF, London Times, MJK Associates, NBER, The New York Source: London Times, MJK Associates, The New York Times, The Wall
Times, USDA, USGS, The Wall Street Journal, and AllianceBernstein Street Journal, and AllianceBernstein
*Historical analysis is not a guarantee of future results. We collected inventory data in order to empirically test the theory that inventory dynamics are an important driver
of commodity futures returns.
14 AllianceBernstein.comSurvivorship Bias: Commodity Futures Risk Catastrophic Underperformance
When a Commodity No Longer Trades
Relative Performance of Discontinued Futures Contracts
Because commodity futures returns depend in large part on Life of Contract vs. Contemporaries (1900–2009, Annualized)
roll returns, any structural decline in the relationship
6.1
between spot and futures prices is a cause for concern. In
the historical record, eight major commodity futures‡ ceased
active trading after structural shifts reduced the risk of
stockouts and hence the need for a risk premium provided –1.4
Percent
–2.8
by roll return. Lard demand, for example, terminally –3.8 Average: –5.0
declined following the adoption of vegetable oils during –6.9 –6.6
World War II. Similarly, egg supplies became more reliable
–11.7
following World War II, when technology made year-round –12.9
production possible. On average, these deceased contracts Eggs Potatoes Rye Lard Wool Cottonseed Hides Rubber
underperformed their contemporaries by a roll-induced 500 Oil
basis points per year over their lives, as seen in the display Historical analysis is not a guarantee of future results.
to the right. Source: MJK Associates, The New York Times, The Wall Street Journal,
and AllianceBernstein
Could a structural change impact the required risk premium
of a major commodity today? Natural gas—which is the Government Interference
second-largest weighting (over 10%) in the Dow Jones-UBS The longer historical record highlights another cause for
Commodity IndexSM—faces a number of potential structural concern: Commodity investors have often had to contend
challenges to its supply-demand dynamics. Thanks to liquid with government interference during times of sharply
natural gas and the broad implementation of “hydraulic rising prices. In both the World War I and World War II
fracturing” drilling technologies, recent estimates put commodity booms, the US government implemented price
supply at levels sufficient for at least another 100 years, controls that essentially halted trading for most commodity
contributing to record-low roll returns. More disconcerting, futures. Interestingly, while the controls always took the
however, is the possibility that passive, long-only investment form of price ceilings for imported commodities such as
flows into commodity futures over the past couple of years sugar, they occasionally took the form of price floors for
have permanently lowered the risk premium required across domestically produced commodities such as wheat. The
all commodity futures. In particular, the longer-term political rhetoric directed at oil “speculators” since 2008,
behavior of roll return in relation to inventories suggests when the price of (mostly imported) crude hit $140 a barrel,
that the risk premium embedded in energy futures has suggests that the risk of political interference remains alive
fundamentally diminished. Due to this prospective decline and well. Clearly, the potential for such untimely interfer-
in roll return, we have reduced the historical return from roll ence reduces the reliability of commodity futures as an
by 200 basis points in all of our analyses. inflation hedge. n
‡Cottonseed oil: 1917–1967; eggs: 1950–1980; hides: 1932–1967; lard: 1900–1962; potatoes: 1950–1987; rubber: 1929–1965; rye: 1922–1970; wool:
1944–1974
Deflating Inflation: Redefining the Inflation-Resistant Portfolio 15(continued from page 13) however, are fully subject to federal taxes, which can make an ILB
different hypothetical inflation-hedging portfolios compared allocation cost-prohibitive to a taxable investor.9 Fortunately, by
with their traditional counterparts over time. While on average overlaying a municipal bond portfolio with “inflation swaps,”
each category of inflation protection would have outperformed taxable US investors can obtain the inflation sensitivity of TIPS with
during episodes of rising inflation, each would likewise have tax efficiency approaching that of traditional municipals.10
detracted from performance in normal times (i.e., periods
characterized by low or declining inflation). And “normal,” by Taxable investors also face tax costs when investing in Real
definition, means most of the time, so this could add up to a Assets. Most forms of commercial and multifamily real estate,
significant cost over long time horizons. And as the set of bars for example, throw off large amounts of potentially taxable
17% 100% 17% 100%17% 100%
on the right shows, this protection comes with a potential income. Similarly, in the US, commodity futures face 60%
21% 21% 21%
downside: In a deflationary environment, inflation hedges can 17%long-term100% and 40% short-term
17% capital
100% gains
17%tax treatment
100% on
16%
detract significantly from a portfolio’s overall return. 21% 16%
any realized21%gain. And16% physical gold
21% gets treated as a “collect-
17% 100% 17% 100% 17% 100%
37% 37%ible,” subject 37%to a 28% tax on realized gains. If a taxable
16% 21% 16% 21% 16% 21%
Finally, taxable investors should consider 17%investor100% 17% 100% 17% 100%
37% the possibility of 37% faces
37%the full brunt of these taxes, then the inflation
16% 21% US
additional “tax drag” from9%investing in real investments. Most 16%
protection 16%
21% by Real Assets may not 21%warrant the
9% 9% 17% afforded 100% 17% 100% 17% 100%
37% bond allocation
taxable investors will source an inflation-linked 37% associated 37%
return give-up relative to a more traditional (and
16% 21% 16% 21% 16%21%
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