Protecting a Portfolio Against Inflation

I was directed to a research report written by AllianceBernstein about how an investor can prevent inflation from eating into real returns for a target date fund.  Target date funds are a relatively new asset allocation product that adjusts the percentages of each asset during the length of the investment.  This is called the glide path.  The asset mix is higher for riskier assets (i.e. equities) early.  As time goes by, the asset mix becomes more conservative with a heavier weighting in bonds as the fund approaches its target date.  Although the paper was written for target date funds specifically, it can be applied to any traditional portfolio.

Spikes in inflation can be considered a rare tail risk event (three times since World War I).  When it happens, they reduce the value of investment portfolios considerably.  Once the spike is identified as such, buying any protection skyrockets.  The addition of real assets can serve as a hedge against this event.

AllianceBernstein considers three factors when analyzing hedges:  sensitivity to inflation, reliability and cost-effectiveness.  The sensitivity is how an asset reacts to inflation.  Equities has a -2.4 sensitivity.  When inflation is up 1%, equities fall 2.4%.  20 Year Treasury bonds have a -3.1 sensitivity.  Treasury Inflation Protected Securities (TIPS) have a sensitivity of 0.3 to 0.8, depending on the duration of the bond.  Commodity futures have a sensitivity of 6.5.  The second factor, reliability, tells how often the sensitivity factor is correct.  For example, commodity futures have a reliability factor of 54%.  When inflation rises, then the futures may rise but it only does so half the time.  The chart shows that TIPS are the most reliable, then commodity stocks, REITS and commodity futures.  Buying these assets have an opportunity cost.  The investor is giving up returns to buy this insurance against inflation.

Here is a list of hedging assets:

• Equities - natural resource and real estate sectors
• Commodity futures
• Currency forwards
• Real Estate
• Gold
• Short term bonds
• TIPS

The report recommends a portfolio of commodity futures, equities and currency forwards.  The weight depends on the lifecycle of the investor.  Of the investor is still working, it should be about 5%-15%.  At retirement, 15%-35%.  After 10 years of retirement, 30%-50%.